‘Tax tips’ - essential tax management strategies for grain growers
Author: Brian Wibberley (WSA Chartered Accountants) | Date: 27 Mar 2019
Take home messages
- Tax planning is more than having a one year at a time strategy, it requires a long-term strategic plan.
- To implement the plan, you need the correct tools and strategies and you need to know how they can work in your business.
- You need to work closely with your accountant who should be proactive in their advice.
- Laws change constantly. The role of your financial adviser is to keep abreast with these new ideas and strategies.
- A key issue is; all tax planning strategies must have a commercial purpose to create more wealth and improve the performance of your business. Expenditure just to avoid tax is pointless!
The material presented in this paper is for discussion and educational purposes. Every attempt has been made to ensure that the contents are accurate and up to date. However, by its very nature taxation law is subject to varying interpretations and constant changes.
We recommend that readers conduct their own investigations and, where necessary, seek their own professional advice prior to adopting or implementing any concepts, ideas or strategies outlined in this document.
We stress that the contents of this document are our ideas and strategies. Not those of the Tax Institute or any of its staff or members.
The aim of this paper is to encourage discussion and comment with a view to improving advice to primary producers in this complex area of the law and commerce. We welcome any feedback that readers may wish to contribute in light of our comments and views.
We emphasise we are not taxation lawyers; we are general practitioners, who grapple with the day to day complexities of our clients’ lives and businesses.
We trust that you will find the content of this presentation useful in your business.
Income tax - why is it important to primary producers?
An important element of managing a business is the management of income tax.
Income tax and wealth creation go hand in hand. The better a farm business manager can minimise the effects of income tax the better the business performs.
Unfortunately, many primary producers are paying excessive tax because there is no strategic tax management plan, their advisers lack experience and knowledge, or in some cases the primary producers are reluctant to pay for appropriate advice.
This is disappointing as the Australian Government, in an effort to promote and stimulate primary production, provides primary producers with a wide range of very generous tax concessions.
Taking advantage of these generous tax concessions requires a sound knowledge of the law, agriculture and long-term strategic plans.
Unfortunately, in many cases, tax planning occurs on a once a year basis. If it has been a high-income year or there is a large capital gain, there is a lot of activity. If the year is not so good, little is done in regard to tax planning.
Although people are often advised solely of their tax outcome using this approach, effective tax planning does not work like this.
Strategic tax planning requires a longer-term approach very much like primary producers’ approach to their crop rotations or livestock management.
Strategies need to be structured and put in place years before they may need to be used. This is because it can take some time to implement appropriate strategies that are impossible to create and implement in one high income year.
To be able to do this effectively, the primary producer has to learn and understand how all of these processes and strategies work. They cannot rely entirely on their income tax accountant whose knowledge of the practical aspects of agriculture may be limited.
This is not to say the farmers can do this without professional advice. Income tax, superannuation, state taxes like stamp duty and other commercial laws are constantly changing and being updated.
This being the case it is essential that the primary producer employs a professional adviser that is well trained, highly skilled, experienced and up to date with their taxation strategies and advice. This is not always the case. Tax accountants can be like chalk and cheese. They can look the same but when you taste them, they taste entirely different.
Primary producers must ensure that their professional adviser attends regular professional development training and constantly brings to the client/adviser relationship new ideas and concepts to assist the business’s performance.
Merely attending to the annual tax compliance requirements of the business by preparing historical financial statements and tax returns for the Government provides little value to the business. It is a necessary cost however it provides no real benefit when it comes to generating wealth and sustaining the long-term viability of the business.
Primary producers need to ask themselves: ‘What new ideas and advice have I received from my accountant that has saved me money or created wealth?’
If it is not much. Look for a new accountant.
A good relationship between you as the primary producer and your accountant as your trusted financial adviser, is essential.
So, what is tax planning all about?
Basic income tax knowledge
To fully comprehend and understand effective tax planning, primary producers need to understand how the income tax system works. Needless to say, this is very complex however some important basic concepts are as follows: -
Net assessable income
Net assessable income is not necessarily the net result of cash in and cash out.
Net assessable income is the sum of your trading income, net capital gain and statutory income less allowable tax deductions.
Statutory income and expenses are not necessarily cash inflows or outflows. They are income and expenses because the legislation deems them to be involved in the calculation. Examples include accelerated tax depreciation that is an allowable tax deduction or franking credit income on share dividends, etc.
When it comes to allowable deductions Section 8.1 of the ITAA 1997 states: -
- A taxpayer can deduct an amount from their gross assessable income any loss or outgoing to the extent: -
- It is incurred in gaining or producing assessable income, or
- It is necessarily incurred in carrying out a business for the purpose of producing or gaining assessable income
- However, you cannot deduct a loss or outgoing to the extent that: -
- It is a loss or outgoing of capital or of a capital nature, or
- It is a loss or outgoing of a private or domestic nature, or
- It is gained in producing or gaining exempt income, or
- The Act prevents it e.g. Div. 35 – Non-commercial losses etc.
The income tax year
For most taxpayers their net assessable income is calculated on the gross assessable income derived less allowable tax deductions incurred during a specified period.
This is from the 1 July in one year to the 30 June in the next calendar year.
Because of this specific time frame, it leads to the concept of whether a taxpayer calculates their net assessable income on a cash basis or an accruals basis.
A cash basis is where the gross income recorded is physically banked into their bank account or a cash payment is physically paid out of their bank account during the specified tax year.
The accruals method is where a business has generated income within the specified period however they have not physically received the amount at the end of the period. It is owed to them. When it comes to expenses these expenses have been incurred before the end of the period however they have not physically been paid. The business has a debt at the end of the period, or as it is most commonly called, a creditor.
This concept of the income tax year, cash accounting or accrual accounting is especially important in primary production tax planning.
Most primary producers in Australia appear to use the cash receipts basis of accounting for income, however when it comes to expenses there seems to be some confusion. Some people accrue creditors and others don’t. Sometimes they change their approach!
Unfortunately, there has been little recent guidance by the Australian Tax Office. There were some earlier income tax rulings in relation to grain income where grain was sold via the pool system [Tax Rulings TR 2001/1 and TR 2001/5], with other tax rulings and Australian Tax Office (ATO) guidelines on whether people should account on the accruals or cash basis [TR 98/1].
As the TR 98/1 ruling outlines, at the end of the day, the method chosen is supposed to reflect the correct ‘reflex of income in a relevant year.’
Clause 17 states: -
‘When accounting for income in respect of a year of income, a taxpayer must adopt the method that in the circumstances of the case is the most appropriate. A method of accounting is appropriate if it gives a substantially correct reflex of income. Whether a particular method is appropriate to account for the income derived is a conclusion to be made from all the circumstances relevant to the taxpayer and the income.’
From experience modern-day primary production is involved and complex. At any point in time, produce is at all stages of processing and storage. Grain can be unharvested or harvested, stored in bags in the paddock, silos or bins. It can be delivered to the silo or bin and warehoused or it can be sold using a range of different contracts which include cash payments 21 days from delivery, fixed grade or multigrade contracts, on a deferred payment contract (payment usually after 30 June the following financial year) or sold on a pool distribution basis.
Given the quantities (in tonnes) involved it is often a major accounting exercise to determine at 30 June each year exactly where the produce is, how it has actually been sold and for what price.
Despite some research we are still unsure how some grain marketing bodies, openly advertise that producers can deliver grain (effectively selling at an agreed amount and at a set price) on the basis, if they elect a deferred payment option (after 30June that year), that the sale will become assessable income in the following year. We do not know what basis they can do this – maybe they have a private ruling? Who knows?
It is as a result of the practical aspects that are involved that most accountants, we observe around Australia account for primary producer’s income on the cash receipts basis as opposed to the accruals basis. The income from sales are assessable when banked.
It appears the ATO have been prepared to accept this approach provided it is consistent from one period to the next.
This strategy can provide some opportunity to smooth out taxpayer’s income and associated income tax in a high-income year provided this practice of cash receipts accounting is consistent from one period to the next.
Delaying the physical sale of produce can result in increased financial risk as was evidenced with the 2015 and the 2018/19 harvest where prices for warehoused or undelivered grain after 30June 2015 and after harvest 2018 were significantly less than if the producers had sold their grain at harvest. This cost some producers thousands of dollars of income and it probably would have been best if they had sold the grain early and paid the tax at the time.
At the end of the day, given the opportunities that are available to delay income via farm management deposits (FMDs), and the effects of primary production averaging, it really doesn’t matter provided the income is returned at some stage.
Stock on hand
Closely associated to the timing of income receipts is stock on hand.
Accounting conventions dictate that grain or hay that is harvested and is being stored pending future sale must be recorded as trading stock on hand at the end of the year. It should be noted that feed or seed retained to sow next year’s crop or feed for animals is excluded.
There are three methods provided in the ITAA 1997 Section 70-45 to record this stock on hand value: -
- At cost,
- Market selling value, or
- Replacement value.
The Commissioner of Tax has indicated that they will accept average cost or standard cost calculations under the cost method so the taxpayer can calculate this based on their own data and industry benchmarks.
Although all this sounds good in theory and in fact may be practical in some primary production industries, the reality of the matter is that it is very rare that we see primary producers recording stock on hand other than with livestock.
As we stated previously, many primary producers have a considerable amount of stock at all sorts of different stages of sale with no idea of how much they are eventually going to be paid. Further to this, given the complexities involved in producing the produce, it would be challenging and cost prohibitive to establish a production cost per unit.
Similar to the timing of cash receipts, it is really not a great issue if the primary producer records stock on hand or not, provided the stock is eventually sold and the income returned.
The primary production tax rate (PP Average)
The level of tax a primary producer pays is calculated on their average rate of tax which is called primary production averaging [PP Ave].
Primary production averaging is very valuable to primary production families; however, it appears to us, that often the benefits that PP Ave can provide for family groups, are largely overlooked by the accounting and taxation community.
This is especially evident where we see: -
- Family member averages quickly run up to their maximums,
- Younger members of the family being paid PAYG wages as opposed to distributions,
- Rents being paid to land owning trusts – converting PP income into non-PP income
- Distributions to corporate beneficiaries where once again the benefits of PP averaging are lost,
- Situations such as the failure to take advantage of new entrants to the family business e.g. children turning 18, new wives and husbands, etc, and
- Situations where the business is conducted in a company rather than a family trust.
Division 392 of ITAA 1936 sets out the rules for the averaging of assessable incomes for primary producers. Unless the taxpayer elects irrevocably to discontinue income averaging, the rules apply irrespective of whether it produces a tax advantage in relation to a particular year or not. There is currently legislation tabled to allow primary producers to elect to go back onto averaging after 10 years.
Primary production averaging provides relief by way of a tax offset when the average income is lower than the taxation income, and can result in additional tax when the average income is higher than their assessable income.
Averaging only applies to individuals engaged in the business of primary production as detailed in definition contained in Section 995-1 of the ITAA-1997 and does not apply to corporate entities. When it comes to calculating the basic taxable income for the averaging calculation it excludes capital gains and various employment and superannuation receipts.
The concept of averaging is based on the following assumption.
Under normal circumstances a taxpayer’s income tax is calculated using the sliding marginal tax rate scale plus 2% Medicare where applicable (Table 1)
Table 1. Sliding marginal tax rate scale plus 2% Medicare where applicable.
0 – 18,200
18,200 – 37,000
37,000 – 90,000
90,000 – 180,000
What the averaging system is designed to do is avoid excessive tax in high income years as a result of fluctuating incomes (Figure 1).
Figure 1. Diagram of fluctuating incomes across a number of years (1-5).
In this scenario (Figure 1) excessive tax would be experienced in years 1, 3 and 5.
When the system applies in a high-income year the taxpayer receives what is called an averaging rebate (AR) or reduction in tax for that particular year. It reduces the tax rates back to the rate of tax that is calculated on the five-year average. In low income years the opposite can occur, and the taxpayer can pay a higher rate of tax resulting in more tax, complimentary tax (CT) than if their tax was calculated under normal marginal rates (Figure 2)
Figure 2. Example of how primary production averaging works in terms of levelling out tax paid.
To commence on averaging a primary producer needs to be engaged in primary production (PP) and has to be in receipt of two or more consecutively increasing years of PP income: -
Table 2. Case studies indicating when possible to commence on primary production averaging.
When it comes to PP income received from a trust, section 392-20 of ITAA 1997 states that the trust has to be engaged in primary production, the beneficiary has to be presently entitled to some or all of the trust income and the distribution should be in excess of $1 040. In the event the income distribution is less than $1 040, the Commissioner can deem that the tax payer remains on PP averaging, however the Commissioner has to be convinced that the low-income year is not designed to take advantage of the PP averaging provisions.
Special rules apply in Section 392-20 (3) & (4) in relation to fixed and non-fixed trusts that incur a loss year.
Under section 392-22 the trustee of an unfixed trust can nominate a chosen beneficiary(s), being a beneficiary(s) that has either received primary production income in previous years or up to 12 other beneficiaries, to be chosen primary production beneficiaries of the trust.
This nomination has to be in writing and signed before the lodgement of the trust return in the year of the loss. The nomination does not need to be lodged with the ATO however it must be retained with the signed tax return for reference in the event of audit.
In the event that a taxpayer does not engage in a primary production business in a particular year and they are not chosen as an eligible beneficiary of the PP trust, the PP averaging for the tax payer can cease. If this occurs, and the taxpayer has not elected to go off averaging, averaging can recommence in a subsequent year, however the taxpayer has to recommence the averaging process again.
The PP averaging calculation only takes into account the PP income. In a situation where there is non-PP income (NPP) the calculation includes up to $5,000 of NPP income in the calculation and thereafter a sliding scale amount up to a maximum of $10,000. Any NPP income over the $10,000 threshold is taxed on the marginal tax sliding scale less an amount for the eligible PP averaging rebate.
Used effectively in a family group, averaging can be a useful way to manage the family’s overall tax liabilities as we will demonstrate later in this paper.
Capital versus revenue
A final concept that is very important if you are a primary producer is the concept of whether your income is assessed on Revenue Account or Capital Account.
Revenue Account is income and expenses involved in running your business. This can include income such as wheat and sheep income and expenses include items such as fuel, sprays, fertiliser, etc.
Capital account is income and expenses involved in buying and selling capital assets. A typical example is where you buy a block of land. You keep the land for some time and you eventually sell it for more than what you originally paid. The difference between the original purchase price and the eventual sale price is what is called a capital gain.
The key tax planning strategy here is that you pay tax on 100% of your revenue income at your average tax rate.
When it comes to capital gains however, the current legislation allows you a 50% discount, reducing the amount you have to pay tax on to half.
When used effectively in a primary production business this can be a very powerful way to increase wealth.
It should be noted the Australian Labour party (ALP) have announced that they will reduce the general capital gains tax discount from the current 50% rate to 25% if elected in the 2019 Federal election.
Tax planning – what does it involve?
PART IVA - ITAA 1936
All taxpayers need to be conscious of Part IVA when it comes to tax planning.
All taxpayers are entitled to organise and arrange their financial affairs to minimise their income tax liabilities provided they abide by the law.
Part IVA is a provision in the 1936 ITAA that may be applied by the ATO to deny a taxpayer the tax benefit of a scheme they entered into to reduce their income tax. A scheme is defined as an agreement, arrangement, promise or undertaking, a plan, proposal, course of action or course of conduct. It is very broad.
The tax office can apply Part IVA provided they can identify that the sole and dominant purpose of the scheme is to derive a tax benefit. What they are looking at here, is why did the person enter into the scheme? Was it purely to derive the tax benefit or was there some other commercial benefit?
With this in mind it is essential when it comes to managing income tax that there is a commercial reason behind undertaking the strategy and that the tax benefit derived is incidental to that commercial activity.
Luckily when it comes to primary production many of the tax planning strategies that are employed do have a commercial purpose such as risk management, etc.
Tax management strategies
When it comes to tax management, we believe there are three general approaches: -
- Statutory Tax Planning,
- Traditional Tax Planning, and
- Advanced Tax Planning
Usually traditional tax planning and statutory tax planning strategies are bundled together however they can be used independently. Likewise, advanced tax planning often involves all three strategies.
The main difference is that with traditional tax planning and some statutory methods all that happens is that the income and associated tax is only diverted or deferred from one period to the next.
Often the aim is to defer the income to the next period where hopefully, as a result of reduction in production due to seasonal events, the deferral income can be offset against deductions or losses in that later period.
In effect the strategies are aimed at just evening out tax liabilities not eliminating them.
Advanced tax planning on the other hand is designed to legitimately reduce and eliminate tax.
Statutory tax planning
Statutory tax planning involves using provisions within the Income Tax Assessment Acts (1936 and 1997) that provide primary producers with various tax concessions:
Primary production averaging (PP Ave)
The first of these include primary production averaging which was covered previously.
Primary production averaging when used with other techniques such as income splitting via trusts can provide significant benefits to primary producers.
Other useful techniques can be used with new entrants to the family business such as new wives, son in laws and children turning 18.
As stated previously the excellent benefits of PP ave is often overlooked by many accountants.
There are various provisions in the ITAA (1936) that allows PP to delay income in certain circumstances: -
- Forced disposal of livestock – Section 385E.
- Insurance for loss of livestock and trees – Section 385F.
- Double Wool Clips – Section 385G
Capital write off deductions
From the 2015 budget and from August 2018 there are now immediate tax write offs under Division 40F & 40G ITAA 1997 for: -
- Water facilities – dams, tanks, bores, pumps, pipes.
- Fodder storage facilities.
In addition to this there are special capital write off provisions for: -
- Horticulture and grape development costs.
- Ten year write off for power and telephone conveyance.
- Land care deductions.
Choice of trading classification
In more recent times under Division 328 of the ITAA 97 we now have the concept of Small Business Entities (SBE).
The choice as to whether a taxpayer elects to become a Small Business Entity is determined by the level of their aggregated gross business turnover.
Provided this turnover is less than $10 million then a taxpayer can elect to use these provisions.
These provisions provide the following benefits for primary producers: -
- Immediate tax write off for new items purchased under $20 000 in value.
- Accelerated depreciation for depreciable items via the pooling system:
- New assets are written off at a rate of: -
- 15% in the first year, and then
- 30% in a general pool thereafter.
- Simpler trading stock rules.
- Write-off of prepaid expenditure.
- Small business income tax offset, and the
- Ability to restructure small business entities without adverse consequences, etc
In addition to these tax benefits there are special concessions in relation to capital gains tax for entities where their aggregated gross business turnover is less than $2 million such as: -
- Access to the 15-year CGT exemption,
- Further reduction in capital gain by 50%,
- Rollover capital gain another active asset, and
- Rollover of capital gain into an eligible superannuation fund.
Special rules apply to companies and trusts.
In some instances, it may appear these concessions are not available however there’s always a way in which affairs can be managed to take advantage of these provisions.
Although in isolation some of these tax placing opportunities may appear quite limited when used in conjunction with other strategies, they can be quite powerful in minimising income tax liabilities.
Traditional tax planning strategies
Derivation of income
Associated with the concept of cash versus accrual accounting is the timing of income receipts.
Where a primary producer accounts for income on the cash basis there is always the opportunity for the primary producer to select when they wish to declare their income.
They then have a choice such as deferring income to the next year.
They can do this in a number of ways; they can physically hold the grain on farm, in warehouse, or sell on a deferred contract.
One of the questions that always comes to mind is ‘how do people get away with selling grain on a deferral contract?’ Theoretically, once a grower has disposed of a known quantity and grade of commodity for guaranteed fixed price then he/she has sold the grain. It appears however provided the grower is accounting for income on the cash receipts basis then the income is only assessable when they receive physical payment.
Another issue that comes to mind is that of trading stock. Theoretically harvested unsold grain and produce should be brought to account at the end of the year as trading stock on hand. This stock can be valued at cost. The reality of the matter however is that primary producers can have stock all over the place and it is probably cost prohibitive time to value and account for the stock as the ATO would like.
The net result is that in about 95% of situations, produce sales are only brought to account when the physical money is received.
Another risk of delaying the sale of grain either on-farm or in warehouse is the market risk of the value of grain going down in value post-harvest. This needs to be seriously considered.
Timing of deductions
As with the derivation of income the timing of the incurring of allowable deduction relates to whether someone is accounting using the cash or accruals method.
There can be quite valuable tax planning opportunities by prepaying expenses. If the primary producer is accounting on the cash system, they must physically pay cash before 30 June.
We stress to our clients that they take physical possession of the goods once they pay for them. We have seen situations where people have paid for fertiliser pre-30 June that was never delivered because the supplier went broke.
For those taxpayers who are not small business entities there are appointment rules for prepaid deductions.
In addition to prepaying expenses is the concept of just spending money to avoid tax. In situations like this people are relying on Section 8.1 of the ITAA. We do not recommend this strategy unless the expenditure is on something worthwhile.
Farm management deposits
Division 393 of ITAA 1936 – Details what FMDs are and how they operate.
Section 393-1 says: -
You can deduct a farm management deposit if: -
- You are an individual carrying a primary production business (including a primary production business you carry on as a partner in a partnership or as a beneficiary of a trust) and
- You hold the deposit for at least 12 months, and
- You meet some other tests namely: -
- Your non-primary production income does not exceed $100 000 in the year in which the deposit is made,
- You continue to be a primary producer for the whole period that you hold the FMD,
- You do not become bankrupt or die.
FMDs are in effect a term deposit lodged with an eligible institution.
The objective of the FMD scheme is to provide relief to primary producers by enabling them to better manage cash flow through profitable and unprofitable years by smoothing the levels of their assessable income and by minimising the variations in tax liability which might otherwise occur over a number of years.
To be eligible to lodge an FMD you need to: -
- Be engaged in the business of primary production as either an individual or a partner Section 393-25(2) or an eligible beneficiary of a trust, Section 393-25(3).
- Your non-primary production income must not exceed $100 000. Note however under Section 392-85 (1) that you can use other non-primary production deductions such as super contributions to reduce non-primary production income.
Non-Primary Production Income $120 000
Less Super Contributions (25 000)
Non-Primary Production Income $95 000 eligible for FMD
There is a maximum that individuals can accumulate in FMDs. The cap is now $800 000 per person. The minimum deposit is $1000.
Section 393-40 (1) specifies to be eligible for the deduction the deposit must remain on deposit for a minimum period of 12 months, unless there is a severe drought event or natural disaster. The terms and conditions of the severe drought event are described in Section 393-40 (3) and for natural disasters Section 393-40(3A).
If the deposit is withdrawn before the 12-month period and there has been no drought or natural disaster, then the taxpayer’s tax return needs to be amended for the year in which the deposit was claimed.
After the mandatory 12-month period when the FMD is eventually withdrawn it becomes assessable primary production income of the depositor. If the depositor dies or becomes bankrupt the deposit must be withdrawn and it becomes assessable income of the individual or estate.
There are special rules that apply to beneficiaries of trusts. These are detailed in Section 393-25 to 393-28.
Section 393-25(3) specifies that provided you satisfy the requirements of sub sections (4) and (5), that as a beneficiary of a trust that engages in primary production, you are eligible to lodge FMDs.
Subsection (4) says you satisfy the requirements if: -
- You are a beneficiary of a primary production trust, and
- You are presently entitled to a share of the income of the trust for that year
Subsection (5) refers to fixed trusts where there is no trust income for the year, and
Subsection (6) refers to non-fixed trusts when there is no trust income for the year and that you qualify for the conditions outlined in Section 393-27.
Section 393-27 says that in a loss year the trustee can nominate a beneficiary who has previously received a primary production distribution or up to a maximum of 12 other chosen beneficiaries.
As with the averaging provisions the nomination of chosen beneficiaries has to be in writing, signed by the trustee prior to the lodgement of the trust tax return. We are not sure how many people do this in reality. It would be interesting to know.
In the event that you read section 392-20, literally if the trust does have primary production income, an eligible beneficiary has to receive at least $1040 of PP income to remain on averaging to retain their FMDs (Explanatory Memorandum Tax Amendment Bill No 5 2011) unless the Commissioner exercises his discretion in sub paragraph 2(c).
Another method of incurring a tax deduction in the later months of a financial year is the choice as to whether you lease an item of equipment or finance it on an equipment finance contract like a chattel mortgage.
Under a normal finance contract, such as a chattel mortgage, the allowable tax deductions include apportioned interest and depreciation for the period that the item of equipment is installed and ready for use. If this has occurred late in the financial year, there may be little in the way of tax benefit.
Under a lease finance contract, where the item of equipment is owned by the finance company, the primary producer gets the full 100% deduction for the lease payment. So, a lease payment in June will result in a greater deduction than if you took out a chattel mortgage.
The amount of the deduction (or lease payment) is determined by the terms and period of the lease arrangement. The ATO has issued a number of interpretive decisions and tax rulings as to what qualifies as a genuine lease and how much the initial tax-deductible lease payment can be in the first year IT28, IT 2051.
When it comes to income tax streaming there are a range of techniques practitioners can use to stream primary production income between individual members of a family to reduce the families overall tax liabilities.
The key to streaming lies in the selection of the trading entity.
Partnerships are reasonably effective in this process however the partners share in the business income is usually a fixed proportion e.g. 50%/50%, 75%/25%, etc.
Techniques used to get around these fixed entitlements are: -
- By changing the share in the partnership at the beginning of the financial year; or
- Paying a pre-distribution partner’s salary to one partner in exclusion to the other partners.
The ATO acknowledges these practices do occur however they are not completely happy with this activity and one would need to ensure that there is a sound commercial basis to effect either of these approaches.
Selection of a trading structure
The selection of a suitable trading structure for a primary production business should be driven by commercial and family issues such as ownership, control of the business and assets, management, asset protection, future succession and/or estate planning as opposed to just taxation management.
Despite this, the type of structure that you choose can have a significant effect on the family’s ability to manage their taxation affairs over time.
Table 3 provides a quick overview for primary producers of the advantages and disadvantages of various structures. Note: We have not included sole traders or hybrid unit trusts.
Table 3. Advantages and disadvantage of various types of business structures.
Discretionary Trusts with Corporate Trustee
Family discretionary trusts
Family discretionary trusts are in our view, the most effective structure for streaming income.
Special care needs to be taken here to ensure: -
- That you review the trust deed to ensure that the distribution is to an eligible beneficiary,
- That the trustees resolve to distribute the income to the eligible beneficiaries in line with powers outlined in the trust deed, utilising the proportionate approach taken in the ‘Bamford’ case and that this resolution is minuted and signed prior to year-end,
- That in making the distribution the trustee takes into account family and interposed entity elections and the trust streaming provisions contained in Division 6 (Sec 207) in relation to trust distributions, and
- After making the distribution ensuring that appropriate documentation and minutes are completed and signed as a correct record.
When it comes to other entities such as unit trusts, streaming is limited to the fixed or discretionary entitlements (in relation to hybrid trusts) detailed in the trust deed.
There is little ability to stream income via a company other than to have the shares held by a discretionary trust which enables the streaming of the company dividends.
It should be noted that the Australian Labor Party (ALP) are proposing, in the event that they are elected in the 2019 Federal Election, to tax trust income at a flat rule of 30%. Farm trusts (not defined in their proposal) are excluded from this tax regime. What this means is anyone’s guess?
One of the benefits of a family trust is the ability to distribute different classes of income to different beneficiaries in varying amounts (Figure 3).
Care needs to be taken, as we have specified previously, that where the trustee has appointed income or capital entitlements to a beneficiary, it becomes their legal property.
If these entitlements are not withdrawn physically from the trust, they become unpaid present entitlements or effectively at call loans owing to these beneficiaries.
One needs to be very careful about this, especially in the event that the family are trying to achieve the best tax outcome for the group by distributing to various individuals to maximise the benefits of their individual primary production average.
Figure 3. Distribution of income to different beneficiaries within the family trust.
If the trust is used effectively, taking into account unpaid beneficiary entitlements, there is the opportunity to massage the distribution of the overall family’s income, from one year to the next, by maximising the benefits of individual’s primary production average.
This can be further enhanced when you introduce the use of FMDs and corporate beneficiaries (Figure 4).
Figure 4. Distribution of income to different beneficiaries within the family trust further enhanced by the use of FMDs and corporate beneficiaries.
The net result is that eligible beneficiary’s income can go up and down and not necessarily as a result of the climate or the economy.
We have seen people do this in a number of different ways and some care needs to be taken to: -
- Avoid excessive complimentary tax for those beneficiaries with assessable incomes less than their average.
At the end of the day the extra tax is a result of the average so in the event the trustee distributes a smaller amount to these beneficiaries the extra tax payable will be minimal. After all, provided all of the trust laws and documents are completed correctly the amount of income a beneficiary receives is up to the discretion of the trustee.
- You need to comply with Section 392-20. This relates specifically to beneficiaries of the trusts.
In the event that the trust has income, you are an eligible beneficiary of the trust and you are presently entitled to a share of that income, you need to receive at least $1 040 of primary production income in a specific year to retain your averaging.
Failure to receive any income, as a beneficiary of trust that has an assessable income may result in that beneficiary dropping off PP averaging. Some accounting practices put $1 of PP income in their tax return software to keep the beneficiary on averaging.
The following is an example of how trust distributions and averaging can work for new family entrants:
- When large families are involved new entrants can be used effectively provided you take the appropriate level of care in relation to unpaid present entitlements.
Table 4 is a comparison between the tax someone would pay on a PP averaging system as opposed to someone not on the PP averaging system.
Table 4. Comparison between tax paid by individual on a PP averaging system compared with individual not on a PP averaging system.
Tax on Year 5 Income No averaging
Tax on Year 5 Income PP Averaging
Benefit of Averaging
Use of corporate beneficiaries
What we are seeing more of is the use of corporate beneficiaries to assist with smoothing income in high income years.
In high income years trust profits are distributed to an eligible corporate beneficiary. The income is taxed at the corporate rate of 30%.
It should be noted that the SBE rate of 27.5% is only eligible to companies that are classified as eligible base rate entities. These are companies with a gross turnover of $25 million or less where less than 80% of their income is passive income.
In low income years or where there are family members in the group with lower tax averages than the corporate tax rate, dividends can be paid out of the company to the shareholder trust and are streamed to lower income tax paying individuals in the family group.
The use of corporate beneficiaries can be useful to cap family tax rates at 30% or 27.5% however there a number of issues that need to be addressed.
The first of these is that the use of corporate beneficiaries converts primary production income eligible for PP averaging, into non-primary production income.
The second issue is where the distribution funds are then lent back to the operating trust it can create a Div 7A issue. Division 7A was introduced into the 1997 ITAA to discourage taxpayers from taking advantage of the lower company tax rates of 30% and 27.5% instead of paying at their marginal tax rate of 47 %.
The process of distributing to corporate beneficiaries is shown in Figure 5.
Figure 5. Distribution of trust profit to an eligible corporate beneficiary.
To avoid the effects of Div7A, this loan can be placed on an eligible Div7A loan as either a seven-year principal and interest loan or a 25-year principle and interest loan (where it is secured by a first mortgage) or a sub trust arrangement. Interest rates are published by the ATO each year.
If the loan is not placed on an eligible Div7A footing the loan can be deemed as an unfranked dividend to the shareholder. If this is the case the dividend is fully assessable to the shareholders who are unable to use the company franking credits attached to the dividend to reduce their personal income tax.
Net effect is the dividend income is taxed twice, once in the company and secondly in the shareholder’s hands.
The more common of these arrangements seems to be the seven-year loan option. The problem with this is that often the operating trust does not want to repay the principal and interest payment back to the company in cash.
One way to circumnavigate this is for the company to pay a fully franked dividend to the shareholders of the company. This becomes assessable income to the shareholders who in this particular instance can use the attached franking credits to reduce their personal tax. The shareholders then use this net dividend amount [gross dividend less the franking credit] to meet the minimum loan repayment.
This is all good and well provided the shareholders do not have significant primary production income or other income in the year of the dividend repayment. If this is the case the tax rate on the dividend (which came about as a result of the trust distribution to the company – converting primary production income into non-primary production income) can be greater than the tax rate that would have been payable had the distribution been paid to the individuals to start with.
The net result is that although the taxpayer receives a small tax break for a few years there is the possibility that they end up paying a higher rate of tax in the long run.
Primary producers are often not aware of this until it is too late.
One common mistake that we often see is where the shareholders in the beneficiary company are individuals. As a result, the dividends have to be paid to those specific individuals, as opposed to being able to distribute the dividends to other family members, who may have lower tax rates.
This problem can play real havoc in the event you want to combine this strategy with the use of FMDs.
You may end up in a situation where your non-PP income is in excess of $100 000 because the dividend to repay the Div7A loan may be too high. This prevents any withdrawn FMDs from being re-contributed before the end of the tax year, effectively destroying the tax payers FMD strategy.
A better outcome is achieved where the shares in the beneficiary company are owned by a separate discretionary trust. Provided a family trust and interposed entity election is signed, the shareholding trust structure provides the opportunity to stream income to other members of the family.
We note that in both the 2016 Federal budget and the Post Implementation review of Division 7A report presented to the Assistant Treasurer November 2014 that there are proposed amendments to the operation and compliance with Div7A. We are still yet to see whether these recommendations are adopted or not. It is quite possible in their attempt to improve the commerciality of these provisions that they will in fact make compliance even more difficult and cumbersome for our clients.
The debate as to whether it is better to use FMDs or a Corporate Beneficiary to smooth primary production income and tax
There are various schools of thought for large taxpayers whose incomes are reasonably constant as to whether it is best to use FMDs or distributions to companies to manage a client’s income tax.
Table 5 is a summary of the advantages and disadvantages of each strategy.
At the end of the day it is our view the main goal of the professional adviser is to arrive at the most suitable commercial outcome at the same time as mitigating or eliminating tax.
Table 5. Advantages and disadvantages of FMDs compared with Corporate Beneficiary to smooth primary production income and tax.
- Expansion – farm & non-farm asset
- Financing & acquisition of plant & equipment
Another technique to reduce tax and increase wealth is via superannuation contributions.
Unfortunately, the government has restricted the amount of money and assets that can be contributed to eligible superannuation funds by introducing various caps or limits on allowable contributions (Table 6).
Table 6. Caps or limits on allowable superannuation contributions.
$ 25 000 p.a.
$ 100 000 p.a.
$ 300 000 p.a.
3 Year Brought Forward Rule
$ 500 000
Section 152D retirement rollover
$1 480 000
15 Year Rollover
In addition to these caps, taxpayers may be able to use their unused concessional contribution amounts, for up to a period of five years, as an eligible concessional tax deduction in one lump sum. These are called catch up contributions.
In the event the Australian Labor (ALP) are elected in 2019 they are proposing to reduce the non-concessional cap to $75,000, abolish the catch-up concessional contribution, along with a range of other measures that will reduce the attractiveness of superannuation.
Advanced tax planning
Advanced tax planning involves developing strategies using both traditional tax planning and statutory tax concessions coupled with specific provisions in the Income Tax Assessment Act and the Superannuation Act, to reduce income tax.
Over the years we have developed a range of processes and strategies that we call our ‘10 Tools in the Shed.’ We don’t intend to elaborate on these tools in this paper and people who are interested are welcome to explore these concepts and ideas by searching ‘Wibberley’ on the GRDC website.
When it comes to tax planning though the following tools are essential: -
- Trading via a family discretionary trust with corporate trust,
- Owning capital assets in family discretionary trusts with corporate trustees,
- Adopting a flexible finance package,
- Utilising FMDs strategically,
- Setting up a Self-Managed Superannuation Fund,
- Implementing a structural plant and equipment replacement and upgrade capital budget, and
- Acquiring off property investments.
It is not just enough to have the tools. You need to know how to use the tools and processes strategically in your business.
When we take on new engagements the first step is to ensure that they are structured correctly with family trusts.
The next step is to ensure they have appropriate finance facilities. These finance facilities are key, as the business often needs access to cash when disposable cash may not be readily available. When it comes to tax planning, cash is king.
The third step is to start building up the client’s FMD balances. This often involves borrowing initially, as a lot of the business’s cash is tied up in working capital.
FMDs are critical in all tax planning and wealth creation plans as they ensure the plans can be sustained even in low income years. Too often we see plans put in place, only to be abandoned, because of insufficient cash flow in low income years.
FMDs insure against this event, providing valuable cash in adverse times.
People are often critical about how FMDs tie up valuable cash flow and are an inefficient use of capital. Experiences has shown this not to be the case and those clients with the largest balances are always better positioned to undertake aggressive wealth creation strategies than those clients who do not adopt this strategy.
The key to FMDs is to know why you need these and how you can use this wonderful tax concession gift from the government to reduce your tax and grow your wealth.
The fourth key strategy is to start a self-managed superannuation (SMSF).
An SMSF is not an investment, it is a taxation structure. It is what the trustee invests in that are the investments. The real benefits of SMSFs, other than their primary purpose of funding people in retirement, is that they are concessionally taxed.
Taxpayers enjoy tax benefits within their eligible caps or limits as they contribute to the fund.
The superannuation fund itself pays tax at a rate of 15% of eligible concessional contributions and reserve earnings during the accumulation phase of the fund.
In addition to this, and as a result of the capital gains tax general discount, superannuation funds only pay 10% tax on capital gains in the accumulation phase. The accumulation phase is where people and businesses are actively contributing to the fund to build up people’s retirement balances.
When a member retires and commences an account-based pension, provided their personal member’s balance funding the pension is less then $1.6 million, the tax on the earnings both revenue and capital, that fund that pension, are taxed at 0% tax rate.
Further to this, if the member is over age 60, the pension they receive is tax free in their own personal name.
So how does a farm business use this strategy effectively?
It is important to start with a well drafted superannuation trust deed and corporate trustee.
Once the fund is established the trustees (directors of the trustee company) draw up an appropriate investment strategy and apply to the ATO for eligible superannuation status.
The superannuation fund is now eligible to receive contributions and rollovers from other funds.
Obviously if the family are going to rely just on annual concessional and non-concessional contributions it is going to take some time to build up a sizable retirement nest egg.
This is where being a farmer can be very useful.
Farmland is classified as an eligible asset under Section 66 of the Superannuation Industry (Supervision) Act 1993 SISA. This allows a superannuation trustee to acquire farmland from a member or for a member to contribute farmland (subject to the caps) into the superannuation fund.
Further to this Section 71(1)j of the SISA allows the superannuation fund trustee the opportunity to lease the asset to members or their related parties.
These provisions provide for the following opportunity: -
- Where land has been held in excess of 15 years, as an active asset of the member, the member qualifies as a small business entity and complies with the retirement conditions of Section 152B of the ITAA 1997 the member can contribute the capital proceeds of a farm transaction to their superannuation fund up to their maximum CGT cap of $1,480,000 each person.
This being the case, Mum and Dad, where Mum and Dad are aged 64, can contribute the following to their superannuation fund: -
15 Year CGT Rollover x $1,480,000
Not limited to the $1.6 million total super balance non-concessional contribution restrictions
2 x $100,000
Provided their total super balances are less than $1.5 million
2 x $20,000
The contributions can be farmland and is called a contribution inspecie. This is where land ownership is contributed or transferred to the superannuation fund, instead of cash.
In most states in Australia this transfer from Mum and Dad to the fund is free of stamp duty.
Now the farm property is owned in the superfund, the farm business entity can lease the farm from the superannuation fund.
Let’s say the lease is $175,000 p.a.
Mum and Dad have a 0% tax rate up to their maximum pension transfer balance cap of $1.6 million each.
Any superannuation balance in excess of this has to be in the accumulation phase. So it is possible, subject to the contribution caps, for a person to have more than $1.6 million in their superannuation fund. The income on the earnings that represent the accumulation phase funds’ investments are subject to tax at a rate of 15%. Still better than the corporate tax rate or the top marginal tax rate
As their members pension balances are $1.6 million or less the $175,000 is tax free in the fund.
In addition to this, as Mum and Dad are over age 60, any income stream they draw from the fund is tax free.
As they are aged 64, they need to withdraw 4% of their members balance as an income stream each year. This equates to $1.6 million @ 4% = $64,000 each.
An issue that needs to be managed moving forward is that the minimum pension balance percentage that they have to withdraw on an annual basis increases with age (Table 7)
Table 7. Age based rate of minimum pension balance percentage withdrawn on an annual basis.
< Age 65
65 – 74
75 – 79
80 – 84
85 – 89
This can lead to cash flow issues if not managed correctly.
One solution is to have other members in the fund.
It is also important to have an estate plan. In the first instance Mum and Dad may have auto reversionary pensions. These pension terms stipulate the pension of the deceased party continues to be paid to their remainder spouse.
As the remainder party can only have a maximum of $1.6 million in pension phase, they have three options: -
- Cash out the deceased persons balance which may involve transferring some of the property out of the fund,
- Continue with the deceased persons pension and roll the remainder persons pension back into accumulation, or
- Cash out the remainder persons balance.
This all involves proactive planning with the client and provides the opportunity as illustrated in Figure 6.
Figure 6. Diagram of the benefits of utilising self-managed super funds (SMSF) to minimise tax and fund retirement.
The pension member receiving the tax-free pension has a range of options as to what they do with the net proceeds of the property rental. They can -:
- Retain the money in the fund to provide for non-farming children in their estate plans,
- They can use the pension funds to fund their retirement,
- They can withdraw the funds and prepay non-farming children’s estate entitlements, or
- They can return the funds to the farm business to be used to acquire additional farm land, off farm assets (maybe a retirement home), reduce debt or fund operations.
This is only one very powerful example of how to use some of the tax planning strategies in an advanced tax planning strategy.
Tax planning is more than having a one year at a time strategy, it requires a long-term strategic plan.
To implement the plan, you need the correct tools and strategies and you need to know how they can work in your business.
You need to work closely with your accountant who should be proactive in their advice. If they are not providing new ideas and strategies to improve your business, find a professional adviser that can. A good accountant should be more than someone who attends to the preparation of your historical financial statements and tax compliance.
Laws change constantly. Just because the ALP says they will change a range of current concessions it doesn’t mean new ones will not evolve. They always do.
The role of your financial adviser is to keep abreast with these new ideas and strategies.
A key issue is; all tax planning strategies must have a commercial purpose to create more wealth and improve the performance of your business. Expenditure just to avoid tax is pointless.
Think laterally and strategically.
Brian D Wibberley CTA, CA, AAAC
B. Ag. Sci., Grad Dip. (Business), Grad Dip. Education
In addition to being a Chartered Tax Adviser, a Chartered Accountant and Registered Tax Agent, Brian is: -
- A licensed Self-Managed Superannuation Strategist with his own company Provident Strategies Pty Ltd, AFSL 447616, and
- A registered Agricultural Consultant with the Australian Association of Agricultural Consultants, and a member of the Ag Institute Australia No 7294.
Brian has 35 years’ experience working closely with farmers, their families and allied professional businesses in his capacity as a business, taxation and financial adviser.
Brian’s interests in Agricultural Consulting and Education have extended to all facets of Taxation, Farm Management, Succession, Retirement and Estate Planning with a special focus on multi-generational and multi sibling family businesses.
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