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A holistic approach to tax efficient wealth building. Travis Morien Compass Financial Planners Pty Ltd 08 9332 0544 http://www.travismorien.com
There are many perfectly legal and socially acceptable ways to increase your wealth in a tax efficient manner. Some of these methods are very powerful. Legitimate methods of increasing your tax efficiency are called “tax planning”. Methods that are unlawful are categorised under two different labels:
“Tax avoidance” is where you set up contrived accounting structures and strategies that abuse a loophole so you can claim large tax deductions or take advantage of some benefit that was never intended to be used in such a way. “Tax evasion” is where you deliberately try to hide income from the Tax Office, by various methods including secret bank accounts, not recording cash transactions, “cooking the books” etc.
The focus of tax planning
Tax planning should only ever be done with a view to increasing your total wealth. There are some people that enter into all sorts of dubious arrangements in order to obtain a tax deduction, including trying to minimise their income. Minimising your income is silly, what you want to do is increase your assets and/or after tax income. Some popular tax planning strategies are highly effective at reducing your tax, but produce little benefit in terms of wealth creation. Some strategies actually make you worse off, either immediately or in the long term. Hence, tax planning is just a subset of overall financial planning, which needs to take into account investment strategy, retirement planning, wealth building etc.
Legality and ethics
There is always a grey area between tax planning, tax avoidance and tax evasion, and the Australian Tax Office has a surprising amount of discretion to decide where the boundaries lie. It should be remembered that just because some “expert” says it is ok, doesn’t mean that it is ok. Also remember that just because a tax adviser openly advertises the strategy in a newspaper doesn’t mean the Australian Tax Office has approved the scheme. There have been many high profile prosecutions over the years and the fact that “everyone does it” makes the ATO more likely to shut it down. In other words, be careful about listening to advisers that seem to recommend “too good to be true” strategies like clever loopholes and novel types of trust that are supposedly a closely guarded secret of “the rich”. Serious penalties including huge fines and jail terms may apply if you do something illegal. Blaming your advisor usually won’t get you off the hook.
“The Secrets of the Super Rich”
Contrary to what many “poor” and “middle class” people have been led to believe, there really are no secret techniques used by the wealthy that enable them to get through life paying little or no tax. Wealthy people often employ very good advisors but strategies used by the wealthy are almost always the same simple strategies mentioned in this presentation. The difference is that a skilled advisor knows how to best combine these strategies for overall results. People generally get wealthy not by using some flashy “secret” technique, but because they were good at building a business or investing wisely. Gurus promoting the idea of “secrets” are usually conmen seeking to dupe the poor and middle class, you generally don’t find millionaires lining up to attend $10,000 seminars advertised in the newspaper. Most wealthy people that I know scoff at such seminars.
There are many different types of tax planning strategies: Strategies for obtaining tax deductions Strategies for obtaining tax offsets (credits) Strategies for moving income away from an entity paying a high rate of tax to an entity paying a lower rate of tax. either to defer tax or take advantage of a more favourable tax rate. Strategies for moving profits and losses between tax years. . Strategies for reducing the amount of assessable capital gains from an investment sold at a profit.
For example. An offset is a credit against tax payable. claiming a $100 Tax deduction will produce a tax benefit of $48.5%. your total tax bill will be reduced by the full $100. If you are entitled to a $100 tax offset. . you obtain a tax benefit equal to the amount of tax you would have paid on that income at your tax rate.50.Deductions vs offsets When you claim a tax deduction for something. if you are on the top marginal tax rate of 48.
More complex strategies may involve structures like a discretionary trust. . companies and superannuation funds. A common and very simple example of this is when a couple make income producing investments in the name of the partner on the lower tax rate. often a non-employed spouse.Moving income between entities on different tax rates The term “entity” has a very broad meaning and can include different people. the trustee may be able to choose the best way to distribute income between several beneficiaries which may include people or companies.
holiday. Other times. A powerful way to move income from this tax year into a tax year that may be many years from now is to invest in an agribusiness scheme. It might be sensible to defer the sale of any assets trading at a capital gain until the lower income year. ill etc). . then you may be on a lower tax rate then. If you are working now but likely not to be working in a few years (retired. people may wish to bring forward income if they expect a substantial increase in taxable income in the future.Moving income between tax years There are many ways to move income between tax years.
There is actually a small but significant increase in your effective rate of return if you can keep portfolio turnover down. A discount of 50% applies if you hold the asset for more than one year. More tax efficient investing . Many people overlook the fact that if you defer the realisation of a capital gain you get to keep your unrealised tax debt in the market earning you dividends. you need to remit part of that gain to the Australian Tax Office as CGT. Every time you sell an eligible asset at a profit. so medium to long term investments are vastly more tax efficient than shorter term trades. One of the biggest expenses to a successful investor is capital gains tax (CGT).
much of it nondiscountable short term capital gains.Managed funds and tax efficiency It pays to check on the tax efficiency of any managed fund you are thinking of investing in. . Some funds have a relatively low portfolio turnover and tend to actively manage their taxable distributions to reduce the tax burden to their investors. Obtaining such information isn’t easy if you are a general member of the public. Other funds trade excessively. this is where a good financial advisor can be of assistance. and make huge distributions every year.
Tax offsets There are so many different tax offsets that you should talk to an accountant to see which ones you can claim. . Common ones include franking credits on share dividends. low income tax offset. baby bonus and many more. personal super contributions offset. spouse superannuation contributions offset. Senior Australian’s Tax Offset. family tax benefits part A and B. dependent spouse offset.
The higher your income.The three tax systems of Australia Personal income is taxed in Australia on a marginal tax rate system. No discounts apply to capital gains. but is outside the scope of this discussion as it has limited applicability to investment strategies. Capital gains on assets held more than one year are taxed at half of your marginal tax rate. Corporations in Australia pay a flat rate of tax on income of 30%. the higher the average rate of tax you pay. Superannuation funds pay tax of 15% on income and 10% on long term capital gains. . Arguably GST is counted as a fourth tax system. A surcharge may also apply for contributions for high income earners.
001 to $70.000 $2.Personal tax rates for Australian residents 2004/2005 Taxable income $0 to $6.001 to $21.600 $13.000 plus Tax payable* Nil $0 + 17% of excess over $6.000 $70.000 $6.652 + 30% of excess over $21.5% may also apply .000 * Medicare levy of 1.600 $21.000 $18.601 to $58.572 + 42% of excess over $58.612 + 47% of excess over $70.000 $58.
This works out to an effective tax rate of about 31%.000 is $24.000 of income.5% and most tax planning that we do will be on dollars that would be taxed at the highest rate. For example. .512 including Medicare Levy. the marginal tax rate of such a taxpayer is 48. The amount of tax actually paid by someone earning $80.000. you will be on the top marginal tax rate. The top marginal tax rate only applies on the last $10.5%. though of course any additional income would be taxed at 48.Personal tax system cont’d Contrary to what many people think. For long term capital gains (asset held more than one year). your marginal tax rate is not equal to your average tax rate. the capital gain profit is first discounted by 50% and then added to assessable income at marginal tax rates. Including Medicare Levy. if your income is $80.
. rather than the effective top rate of 24.Companies Companies pay tax at a flat rate of 30%. only drawing a dividend when the shareholder’s tax bracket equals 30% or less. A common tax planning strategy is to retain and reinvest income in a company. and can retain income and assets in their own name and need to lodge their own tax returns. This applies to both income and capital gains. Companies are distinct tax entities recognised by the Tax Office.25% paid on long term gains earned in the name of a person. Companies can be used as an efficient “parking” vehicle to defer personal income tax. though investors need to take account of the fact that capital gains will always be taxed at 30%. High income investors often buy investments in the name of a Pty Ltd company so they will be taxed at a maximum 30% on income.
Investments can be made in the name of a trust. . company or a superannuation fund. “Discretionary” trusts give the trustee a lot of flexibility in determining how to make distributions and offer significant tax planning opportunities. trusts are not entities that pay tax. capital gains and capital of the trust. companies. Beneficiaries of trusts can be people.Trusts and other structures Unlike a person. A trust is a “fiduciarial obligation” between a trustee and the beneficiaries. partnerships and other trusts. A “fixed” trust is set up so that all beneficiaries get a fixed entitlement to the income. but all income and capital gains must be distributed to beneficiaries every year or the trustee will pay tax at the top marginal tax rate on undistributed income.
Another advantage of super is that this is one of the most difficult assets for a creditor to get his hands on. so superannuation is ideally suited to business owners and professionals wanting a protected place to store their long term savings. . You only pay 15% tax on income in a super fund and the capital gains tax rate on assets held for more than a year is 10%.Superannuation Although the superannuation system is complicated and many people do not trust it. super is still one of the most tax efficient ways to build wealth.
The pension RBL is $1. The tax efficiency and the asset protection characteristics are so good that limits have been introduced that stop very wealthy people from taking too much advantage of it.Reasonable benefits limits Superannuation is an excellent savings vehicle for long term retirement savings.238. . A “reasonable benefits limit” (RBL) is the most one can take out of super while still obtaining maximum tax concessions.440 in 2004/05. The lump sum RBL is $619. the “pension RBL” by putting at least half your benefit into certain “complying” income streams. rather than withdrawing it and spending it in a short period of time. This figure is indexed each year with inflation.223 in the 2004/05 tax year. The pension RBL is higher to encourage people to convert their super into pensions that will last at least for their life expectancy. You can access a higher RBL.
This figure is indexed upwards every year.Withdrawing from super – lump sums There are various components of super which are all taxed differently (we’ll gloss over the complexities in this presentation). 95% is tax free. Pre and Post 83 untaxed amounts withdrawn in excess of your reasonable benefit limit are taxed at 47% plus Medicare. subject to reasonable benefits limits.5% Medicare). you can withdraw $123. post 83 taxed amounts drawn as a lump sum in excess of your RBL are taxed at 38%. “Post 83” and “Undeducted”. . Undeducted components can be withdrawn from super tax free.808 of “post 83” money from a superannuation fund before having to pay any tax on this lump sum. 5% of Pre 83 money withdrawn from a super fund is taxed at marginal tax rates. The balance of lump sum withdrawals is taxed at 15% (+ 1. In the 2004/05 tax year. the most common components are “Pre 83”.
minus a 15% superannuation pension tax offset. The earnings within the fund itself are tax free once the fund begins paying an income stream.Withdrawing from super – income streams Income streams are taxed at marginal tax rates. the term of the payments and your life expectancy. The size of the deductible component varies depending on the type of income stream. but doesn’t attract the 15% pension tax offset. Pre and Post 83 money withdrawn in the form of an income stream that is in excess of the Reasonable Benefits Limit is taxed at normal marginal tax rates. . Undeducted components create a “deductible” amount of the income stream that is tax exempt.
710 (2004/05 tax year.5%. figure is indexed annually).075 it is 14. This surcharge rate increases from 0 to 14. Below $94. which includes salary. . If your ATI exceeds $99. Adjusted taxable income is your total remuneration.Superannuation contributions surcharge If your “adjusted taxable income” (ATI) exceeds certain thresholds. a formula will apply.075. you may be liable to pay some surcharge on your contributions. If your ATI is inside this range.691 surcharge is zero. just contributions. an additional tax is paid on contributions to superannuation.5% when your ATI reaches $121. superannuation contributions and fringe benefits. This tax does not affect earnings. above $121.
If your remuneration was $85.2.$99. .02036%. your surcharge rate will be 6. you’d pay 6.000 super.02036% x $25.000. in addition to the $3.09 in surcharge.000 salary plus $25.000) you would have paid anyway in “contributions tax”.000 = $1. if your ATI is $110.709. (in the 2004/05 tax year) For example.Superannuation contributions surcharge cont’d Surcharge rate = (ATI . Note that surcharge rates are always worked out to 5 decimal places.710)/1.505.750 (15% x $25.
transport and some selfeducation expenses as deductions. Claiming work. any gearing). Deductions associated with property (depreciation allowances etc). Agribusiness. Negative gearing (in fact. .Strategies for obtaining tax deductions: Salary packaging or direct deductions of business expenses (if eligible).
this is called a “salary package”. When you negotiate a remuneration scheme with an employer that includes salary sacrifice. . You would do this because taking remuneration in the form of a non-cash benefit often means you don’t have to pay income tax on that benefit.Salary packaging A “salary sacrifice” arrangement is a deal agreed to between an employee and an employer to swap some cash salary for another type of non-cash benefit.
but to stop abusive arrangements there is an extra tax paid by the employer called Fringe Benefits Tax. .5%). the employer will have to pass this cost on to you and so you would gain no benefit on many packaged items.Salary packaging cont’d You can salary package virtually anything. (FBT) The amount of FBT paid on items that attract the full rate of FBT is calculated such that the employer pays the same amount of tax as if you had received it yourself and paid the top marginal tax rate (48. Naturally.
laptop computers. some attract a partial amount of FBT and some the full rate of FBT. usually with some sort of lease arrangement. mobile phones and many benefits that would be “otherwise deductible”. Depending on what you use the car for and how far you drive it every year. Common FBT exempt benefits: superannuation. employee share schemes. . The most commonly packaged benefit that attracts a concessional rate of FBT is a car. There is a tax saving if you take FBT exempt items or items that attract FBT at a concessional rate.Salary packaging cont’d Some benefits attract no FBT. there can be a substantial tax saving for salary packaging a car.
000 contributed claimed is called a and 75% of the balance. all contributions for their employees up to the employee’s age based limit. Age ABL MDC* . and the maximum contribution on * Self employed and unsupported which deductions can be people can claim a tax deduction on 100% of the first $5.934 $16. This 50 $94.306 limit is called the Age Based Limit.936 a tax deduction on it.Maximum deductible contributions An employer can only package a limited amount < 35 $13.912 of income into superannuation and claim 35 – 49 $38. Employers Maximum Deductible can claim a 100% tax deduction on Contribution (MDC).980 $126.702 $49.
buy shares. . The tax free threshold for a person under 18 years is only $416.Income splitting Income splitting is a very common strategy and is often quite easy to implement. these tax rates run as high as 66%. managed funds or invest in term deposits) then obviously less tax will be paid than if investments are made in the name of the person on the higher tax rate. being able to potentially choose from a number of beneficiaries. If you can make investments in the name of a spouse on a lower marginal tax rate (for example. but with the low income tax offset it effectively rises to about $643. Note that there are special high tax rates for minors that receive “unearned income”. Discretionary trusts allow a trustee to split income in a very flexible manner.
Income splitting continued You can income split by investing in the name of a person on a lower marginal tax rate or. . provided you have sufficient investment income to make paying the extra accounting costs worthwhile. you can invest via a discretionary trust that allows you to decide every year who gets income and capital gains distributions.
Negative gearing is particularly tax efficient because while the interest shortfall is 100% tax deductible. . the capital gain (assuming there is one) will only ever be taxed at half your marginal tax rate if you hold for more than one year. “Negative gearing” is where the amount of income received from the investment is less than the interest expense. You can also do “positive gearing” where the income exceeds the interest and if you are able to balance the cost it would be called “neutral gearing”. You claim the shortfall as a tax deduction.Negative gearing “Gearing” is the practice of borrowing money for investments like shares or property. When you run the numbers on this. the amount of return you need on your growth investments is less in a simple percentage term than the interest rate on your loan.
Unless you borrow vast amounts of money it is unlikely that the size of the tax deductions will be large enough to make a serious dent on your assessable income. like the risk of margin calls. Some forms of borrowing introduce other risks as well. it is a tax efficient wealth building strategy.Negative gearing continued Negative gearing is not a tax planning strategy as such. That is why I don’t classify this as a pure tax planning strategy. It is important to note that when you borrow to invest you introduce extra risks related to your ability to service the debt and a greater level of exposure to market risk due to the larger portfolio. .
000 at risk in the market.000 to invest means you have $100. and declines of this size are common in both shares and property. If you need to sell the investment you may end up with a debt you can’t afford to pay back.000. .Gearing and risk Although the profits can be fantastic. If there is a decline of 30%. Borrowing $100. There is also interest rate risk. the risks of gearing should not be ignored. you would lose $30. if rates rise significantly people can get themselves in lots of trouble if they have borrowed too much. It is important to always consider whether you are in any position to accept the chance of losses before you invest.
A common strategy that people use toward the end of the financial year is to pre-pay interest to a lender. . This results in bringing forward tax deductions that would otherwise be incurred in the next financial year (but since the dividends from the investment haven’t been received they won’t add to assessable income until next year). you also pay less interest. so not only do you save tax. Most lenders that allow you to pre-pay interest also give a discount on the interest for doing so.Pre-paying interest It is legal to claim a tax deduction on expenses for interest as much as 13 months ahead.
increasing your tax deductions. which means they just keep adding the interest to the account balance owing (up to an approved credit limit). Capitalising interest is sometimes called “double negative gearing.Capitalising interest Some lenders enable you to “capitalise” the interest. The loan balance will keep growing. You can use the cash to either buy more assets or to pay off another loan with a higher interest rate or a non-deductible personal loan.” .
You claim a tax deduction of up to 100% of your initial application money. Normally these types of investment are in the agriculture or film industries. though there are all sorts of other schemes. Tax deductible managed investment schemes (MISs) . but when the project matures you’ll be taxed on 100% of the return. Some investments in primary production schemes are tax deductible.
paulownia and a number of other exotic timbers. coffee and truffles. almonds.Example: Agribusiness The most common type of tax deductible investment is tree farming (silviculture). grapes and some other crops like wildflowers. pine. ginseng. . Also popular are horticultural crops ranging from citrus and tropical fruits through to olives. sandalwood. There are many crops available including eucalyptus hardwood.
and arguably the least risky. as it presents a more environmentally friendly alternative to logging native forests and creates valuable export revenue and employment in rural areas. . is eucalyptus tree farming. and medium term projects (just over 10 years). There are longer term projects (about 20 years) where the wood is grown for sawlog timber and veneer. where the wood is grown for chipping for the production of paper.Hardwood tree farming The most popular type of agribusiness scheme. This sector does in fact receive a high degree of government support.
there may also be deductible ongoing management fees. When the wood is harvested. The blue gums grow for 10 – 12 years. Depending on the upfront payments. the project manager looks after the trees and then arranges the harvest. you receive the proceeds as fully taxable income.000 per hectare is common).000 .How a typical blue gum project works Claim a 100% tax deduction for planting expenses (about $5.$8. .
Moderately high risk: fire. This is an example of moving income from one tax year to another to take advantage of lower marginal tax rates. flood. price movements of the commodity.Investment characteristics of agribusiness No liquidity. Return data is often hard to find. Ideally you would want to invest in them while you are earning good money and paying tax at the top marginal tax rate. currency movements. but retired in the year of the harvest. You usually have to wait more than ten years for a return (though some projects are shorter term). . but a good agribusiness project should produce returns at least as high as equities. Not really tax efficient if you are on the same or a higher marginal tax rate when you get the harvest.
If you have non-deductible debts their after tax cost can be nearly twice as much as deductible debts.“Mortgage accelerator” strategy Interest incurred on a loan to buy into an agribusiness scheme is usually tax deductible. A common strategy is to take out a loan for an agribusiness investment and use the tax refund to pay off a non-deductible debt. for an investor paying the 48.5% marginal tax rate. . The after tax interest bill is basically the same as before except now you have an agribusiness investment and future cash flow advantages.
There is now a “product ruling” system where the ATO certify that they will allow the tax deduction on approved projects provided they comply with the ATO’s conditions. Various “creative” accounting tricks were employed so “investors” were able to claim tax deductions several times larger than the amount actually invested! As a profit was made just from the tax dodge. Result: too many tea trees were planted. Dodgy schemes and the ATO . Many schemes were put together by accountants and lawyers purely for the tax deductions. the price of tea tree oil fell below harvest and extraction costs. “Tax effective” investments have become notorious in the last few years following a widely publicised crackdown by the Australian Tax Office (ATO). Many other crops simply failed to meet prospectus projections. some blue gum plantations were made on cheap marginal land where the trees didn’t grow well. and disallowed tax deductions. The ATO cracked down on these. Far greater effort was put into finding ways to increase the tax deductions than to research the commercial viability of the crop. the crop was just a sideshow.
By claiming a few tax deductions they may be able to reduce their adjusted taxable income to below the $99.How to get out of paying the superannuation contributions surcharge High income earners that salary sacrifice a significant amount of income to superannuation will find that they are paying a significant amount of superannuation contributions surcharge. .710 threshold and thus no longer have to pay surcharge. Common deductions claimed include negative gearing strategies and agribusiness.
When salary packaging a significant amount of money into superannuation. high income investors can pay a significant amount of super contributions surcharge. . the amount of surcharge you can save by claiming a tax deduction can often come close to paying for the agribusiness investment! For some investors taking maximum advantage of salary packaging as well as agribusiness extremely high effective rates of return can be achieved due to the very small net after tax outlays required after factoring in surcharge and other tax savings. If your income is not too far above the upper surcharge threshold and you are putting a lot of money into super.
.Timing and netting of capital gains If you can hold on to your taxable capital gains as long as possible. methods that delay the realisation of capital gains tax can produce significant benefits. The longer you get to hold on to that gain. Therefore. Effectively an unrealised capital gain contains an “interest free loan” from the Australian Tax Office. the longer you’ll be able to earn dividends and further growth on that money. you will obtain a benefit by having that money invested in the markets.
you can only offset that loss against a capital gain. the same can not be said of capital losses. a capital loss is a valuable asset for tax planning purposes and if possible should be realised. . Capital loss credits can be carried forward as long as is necessary for them to be used up. you could buy it back a short time later.Netting capital gains If you sell an asset at a capital loss. you can’t claim a capital loss as a direct tax deduction. Capital gains and losses are “netted”. Each year you pay capital gains tax on the total capital gains minus the total capital losses. These losses can then be used to offset any sales you intend to make at a profit. By being quick to realise losses and slow to take profits you can delay the ultimate paying of capital gains tax for a very long time. In fact. While it is sensible to defer the realisation of capital gains. Generally. If you still like that particular asset.
If you are self employed.Deductible superannuation contributions Employees can’t claim a tax deduction on their personal contributions. to eliminate their capital gains tax liabilities. there are a variety of tests of age and employment activity. you may be able to claim a tax deduction on some or all of your superannuation contributions. The same strategy could be employed to reduce the tax liability on the harvest from an agribusiness project. Note that rules apply specifying who can and can not make contributions to superannuation. . A common post-retirement strategy is for people to liquidate their ordinary investment portfolio and claim a tax deduction on contributions to superannuation. they must use salary sacrifice. or “unsupported”.
This scheme is called the “co-contribution”.05 x ($income&FB . but the main beneficiaries are likely to be part-time working spouses and semi-retired people.500pa.500 – 0. The obvious beneficiaries would be lower income employees.$28.000. reducing by 5c in the dollar as your income exceeds this. and is at a maximum for people with income and reportable fringe benefits below $28.000).000. Co-contributions replace the old $100 super contributions rebate. Superannuation co-contributions . If the formula gives rise to a number below $20. cutting out at $58. and involves the government matching your contributions up to a maximum of $1. The amount of the co-contribution depends on your taxable income. Obviously this benefit is a lot more generous than the one it replaces. Co-contribution = the lesser of your voluntary contribution and $1. the tax office will pay $20. This year a new incentive was introduced to encourage lower income taxpayers to make voluntary contributions to their super.
legal and advisor fees. The benefits of implementing a sophisticated strategy may not be worth the bother in terms of time and money spent on creating and maintaining the strategy unless you have a fairly high income and/or a big portfolio. there are a number of simple strategies that can be relatively easily and cheaply implemented. Such costs include accounting. .One possible downside of tax planning Before implementing any tax planning strategy. you need to consider the costs of doing so.) On the other hand. (Especially when creating tax structures like companies and trusts.
An accountant and a financial planner can assist in implementing all of the strategies mentioned here. a combination of negative gearing. There do exist legal and acceptable methods for reducing tax. but tax planning should only ever be of secondary importance behind wealth/retirement planning. plus many others. but sometimes just taking the money and paying income tax on it is the better long term strategy. salary packaging and agribusiness can reduce the amount of tax paid to very low levels. Summary . Some tax planning methods are very powerful.
Investors should seek the advice of their own qualified advisor before investing in any securities. Information contained herein has been obtained from sources believed to be reliable.Disclaimer: The material in this presentation does not represent a recommendation of any particular security. strategy or investment product. but is not guaranteed. This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. . The author's opinions are subject to change without notice.
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