Family trusts and family companies have been a feature of the financial planning landscape for generations. Family trusts in particular have played a major role in the financial planning of business and professional families, by protecting family assets, providing flexibility when distributing income and capital and ensuring an orderly transfer of assets as part of estate planning. 
More recently, family trusts and companies have been widely touted as vehicles for the alienation of personal services income, tax minimisation through the making or receipt of non-commercial loans and maximisation of social security income support. Consequently, the use of family trusts and companies has become much more widespread. Australian Taxation Office (ATO) figures show that between 1993/94 and 1996/97, the number of trusts lodging tax returns increased 29%, from 336,000 to 427,000. Over the same period, the number of small private companies with total income less than $10 million increased by 31% to about 530,000.

Increasing use of structures for purposes which could eventually impact adversely on government revenues, has led to a situation where the current Government is being forced to take action to curb the use of family trusts and companies for purposes it views as undesirable. 

A range of measures is to be introduced in the near term, which could render such structures largely ineffective for tax and social security planning purposes and significantly reduce the viability of many planning arrangements. 

Changes to the tax treatment of interposed and closely held entities were recommended in the Ralph Report, released by the Federal Treasurer on 21 September. Subsequently, proposals to change how trusts and companies are treated under the social security means test, were outlined in a discussion paper released by the Minister for Family and Community services on 23 November.

Ralph Report tax changes
Loss of flow-through for family trusts 
From 1 July 2001, under the new entity tax regime, trusts are to be taxed as companies. With some exceptions, trusts will pay tax at the company rate. Distributions will be deemed dividends and franked to the extent of tax paid by the trust. 
Whilst many publicly offered investment trusts will be treated as collective investment vehicles, and retain the current flow-through tax treatment for assets held in the trust, it appears unlikely that closely held trusts will retain the current tax treatment. Instead, income and gains will be subject to a uniform 30% tax rate, reducing cashflow to beneficiaries from distributions. 

Capital gains tax disadvantages
Capital gains will not be able to be passed through the trust, so investors will not be able to benefit from the lower proposed CGT rates, due to the new 50% general exemption. Consequently, individuals holding assets directly will pay a much lower rate of tax on capital gains than investors who hold assets in family trusts or companies. From a tax standpoint, it will be preferable to hold assets directly rather than in such structures. 

Personal service income and interposed entities
The use of company and trust structures by individuals who perform services is also to be a target for reform. 
It is proposed that payments received by the interposed entity for services will be treated for income tax purposes as income of the person performing the services. This will be the case where 80% or more of the personal service income received by the entity for the services of the personal service provider, is from the one service requirer (including associates of the requirer). Interposed entities that do not meet this requirement will be able to seek a ruling that they are providing their services in the manner of a personal services business, and outside the scope of the measures. 

Broadly, a personal services business will be a business that would provide services generally to the public at large, accept some entrepreneurial risk in the way it provides its services or provides its own infrastructure. Criteria are to be developed (based on the Ralph Report) to determine whether services are provided in a manner of a personal services business. 

Non-commercial loans
There are proposals to introduce rules, substantially similar to the loan provisions currently relating to private companies (Div 7A), to apply to loans made on or after 1 July 2001 by closely held entities to their members, or the associate of a member. The intention is to prevent the conversion of profits, otherwise taxable in the hands of members, into non-taxable distributions through the use of non-commercial (low interest) loans to members or the forgiving of unpaid balances of such loans. Both of these practices confer a benefit on the member.

Members (or their associates) would be required to include in their income the difference between the rate of interest on the loan and what would be a commercial interest rate to a non-member. Similarly, so much of a loan balance as is forgiven because the borrower is a member (or an associate of a member) of the entity will also be treated as income. 

A measure that has caused considerable concern is a proposal for a ''reverse Div 7A'' system, which would apply to non-commercial loans from a member to a closely held entity. 
The amount of a loan from a member of a closely held entity, or an associate of such a member, to the entity will be added to its contributed capital, unless the loan is ''commercial''. 
All payments on the loan, whether repayments of principal or payments of interest will then be treated as dividends, subject to the ''profits first'' rule, and therefore taxable in the hands of the member. The''profit first'' rule requires that distributions are treated as being from available profits; only distributions in excess of available profits are to be treated as being from contributed capital. 
The new rules are to apply to non-commercial loans made on or after 22 February 1999, although the measure will not apply until 1 July 2001, when the entity regime begins. 
A commercial loan will have the same meaning for a loan made to an entity by a member and a loan made by an entity to a member (essentially the same as for an excluded loan in Div 7A). The loan must be made under a written agreement and comply with minimum interest rate and maximum term criteria. If a loan does do not meet the requirements it will be considered to be ''non-commercial''. 

Social security changes
Under current social security legislation, assets are attributed only where legal ownership or a fixed right to distribution is clear. This means family trusts and family companies can be used to hold and control assets outside the bounds of the means test. 
People can therefore arrange their affairs and be treated more favourably under the means test than a person holding similar levels of assets directly. This is contrary to Government policy of targeting benefits, paid under either the Social Security Act  or the Veteran's Entitlement Act , to those most in need. 
The Government proposes to use specifically designed tests to ''look through'' interposed structures and identify who controls them and the source of their assets. Source and control tests would enable ''ownership'' of assets and income to be attributed to an individual for the purpose of the means test. 
The proposed measures are intended to apply to fixed and discretionary trusts including testamentary trusts, and private companies. 
A control test is to apply, from 1 July 2001, to structures created before that date. Under the control test, the controller of a structure can be considered to be the de facto owner of the structure's assets because they can use the assets for their own purposes. 
It is proposed that the test (based on tax legislation) be broad and cover both formal and informal control that may be exercised. Formal control exists, for example, where a person is the trustee, can appoint or dismiss the trustee or controls the entity through voting power. Informal control exists when a person is capable of gaining control, or trustees or directors can be expected to act in accordance with their direction or wishes. 
A source test is proposed to apply only to contributions made to structures from the date of Royal Assent to the legislation and simplify attribution where the control test is difficult to establish. The source test would attribute a structure's assets to a person if the person transfers assets to the structure for inadequate consideration or provides services to the structure for inadequate remuneration. Underlying the source test is the assumption that a person transferring assets to an interposed structure generally does so either because those assets will be used for the person's benefit or the benefit of their family. An example is to shelter assets from the current means test, while preserving their full value for beneficiaries of their estate.

Structures are to be assessed annually on the basis of financial statements and annual tax assessment. Assessment would be based on the net asset position shown in the structure's balance sheet. If the family home of the controller were included in the structure's assets, it would be treated as an exempt asset. 
Once assets have been attributed to a person, the assets would be held against them for asset testing purposes. Income for social security purposes would be income for tax purposes but with adjustment for certain expenses not accepted as deductions against income. 

Under the existing gifting rules, assets transferred to structures cease to be regarded as assets after five years. Under the new arrangements, such transferred assets will continue to be regarded as the property of the controller and/or donor. 
A need for reassessment of financial planning structures 

Conclusions
Rumours of Government action against the use of structures for tax minimisation and social security maximisation purposes have been circulating for several years. Rumour has now been confirmed by fact in the form of the latest proposals for change. The viability of many structures recently established for tax or social security purposes will be placed in doubt. 
It is time for a reassessment of the appropriateness of most current arrangements involving the use of family trusts and family companies for financial planning purposes.

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