Tax changes causing a farm business rethink

AUTHOR

For generations, Australian farming families have often operated their farming business via family trusts or partnerships.

This allows the family to benefit from certain general tax concessions and specific concessions targeted at primary producers. For generations, Australian farming families have often operated their farming business via family trusts or partnerships.

The primary production concessions that have made these structures preferable are the primary production averaging system and access to Farm Management Deposits (FMDs).

FMDs and averaging are only available to individual taxpayers and are applied when assessing the farming business income that is reported in the personal income tax returns of the farm operators and their families.

These two concessions are designed to smooth the peaks and troughs that are typical of a farming business, bringing greater predictability to the impact of tax on the farm’s cashflow.

Two recent developments to the Australian business tax system are now causing farm operators and tax advisors to question whether these concessions remain as beneficial as they once were.

The first, and more gradual change, has been the lowering of the company tax rate to 25% for small and medium sized businesses. It is important to understand that while a company pays tax at 25% on every dollar of profit, an individual is paying tax at a marginal tax rate of 34.5% (including Medicare levy) once their income exceeds $45,000. From this point, the more income a person earns the less tax efficient the situation becomes.

Once a business owner is earning approximately $100,000, their effective tax rate equals the company business tax rate and will continue to become less tax efficient. This will mean that trust distributions to adult children will only be acceptable in certain circumstances, particularly where there is an expectation that these funds can (or will) be paid.

Secondly, on 23 February the Australian Taxation Office (ATO) released its long-awaited draft position on the taxation of Family Trust Arrangements.

This draft position may evolve and is too complex to address in this article. However, the ATO has stated that they will be taking a restrictive position on the legitimacy of common arrangements observed with the use of family trusts by business owners.

While the list is extensive, the primary examples from the draft that farming families need to understand are where:

Distributions have been made to an adult child and the entitlement to the funds representing those distributions have been applied for the benefit of another person (usually the parents),
Where an entitlement to income has been ‘gifted’ back to the trustee (or a parent) or otherwise forgiven,

Broadly, the ATO is taking the position that the recipient of an income distribution will need to receive the financial benefit of this distribution.

This will mean that trust distributions to adult children will only be acceptable in certain circumstances, particularly where there is an expectation that these funds can (or will) be paid.

This is a problem from a tax planning point of view for business owners, especially those that will not be able to commit the cash of a business to pay the distributions being declared in the names of their adult children. In this case, the number of people able to share the business income of the family will reduce, pushing the income of the primary business owners higher, leading to higher marginal tax rates and a less efficient outcome.

With a higher average tax rate for the family the ability to smooth tax liabilities has less value. So, for farming businesses in a growth phase, that need to retain cash to invest in the farm or reduce debt, moving the business to a company and capping the tax rate at 25% is becoming an option that needs to be considered seriously.