Common Tax Planning Strategies Explained: A holistic approach to tax efficient wealth building Travis Morien Compass Financial Planners Pty Ltd 08 9332 0544 http://www.travismorien.com Basic principles   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 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 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 Strategies for moving profits and losses between tax years, either to defer tax or take advantage of a more favourable tax rate Strategies for reducing the amount of assessable capital gains from an investment sold at a profit Deductions vs offsets   When you claim a tax deduction for something, you obtain a tax benefit equal to the amount of tax you would have paid on that income at your tax rate For example, if you are on the top marginal tax rate of 48.5%, claiming a $100 Tax deduction will produce a tax benefit of $48.50 An offset is a credit against tax payable If you are entitled to a $100 tax offset, your total tax bill will be reduced by the full $100 Moving income between entities on different tax rates    The term “entity” has a very broad meaning and can include different people, 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 More complex strategies may involve structures like a discretionary trust, the trustee may be able to choose the best way to distribute income between several beneficiaries which may include people or companies Moving income between tax years    There are many ways to move income between tax years If you are working now but likely not to be working in a few years (retired, holiday, ill etc), then you may be on a lower tax rate then It might be sensible to defer the sale of any assets trading at a capital gain until the lower income year Other times, people may wish to bring forward income if they expect a substantial increase in taxable income in the future 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     More tax efficient investing One of the biggest expenses to a successful investor is capital gains tax (CGT) Every time you sell an eligible asset at a profit, you need to remit part of that gain to the Australian Tax Office as CGT A discount of 50% applies if you hold the asset for more than one year, so medium to long term investments are vastly more tax efficient than shorter term trades 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 There is actually a small but significant increase in your effective rate of return if you can keep portfolio turnover down Example: Agribusiness   The most common type of tax deductible investment is tree farming (silviculture) There are many crops available including eucalyptus hardwood, pine, sandalwood, paulownia and a number of other exotic timbers Also popular are horticultural crops ranging from citrus and tropical fruits through to olives, almonds, grapes and some other crops like wildflowers, ginseng, coffee and truffles Hardwood tree farming The most popular type of agribusiness scheme, and arguably the least risky, is eucalyptus tree farming There are longer term projects (about 20 years) where the wood is grown for sawlog timber and veneer, and medium term projects (just over 10 years), where the wood is grown for chipping for the production of paper This sector does in fact receive a high degree of government support, as it presents a more environmentally friendly alternative to logging native forests and creates valuable export revenue and employment in rural areas How a typical blue gum project works    Claim a 100% tax deduction for planting expenses (about $5,000 - $8,000 per hectare is common) The blue gums grow for 10 – 12 years, the project manager looks after the trees and then arranges the harvest Depending on the up-front payments, there may also be deductible ongoing management fees When the wood is harvested, you receive the proceeds as fully taxable income Investment characteristics of agribusiness     No liquidity You usually have to wait more than ten years for a return (though some projects are shorter term) Moderately high risk: fire, flood, currency movements, price movements of the commodity Return data is often hard to find, 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 Ideally you would want to invest in them while you are earning good money and paying tax at the top marginal tax rate, but retired in the year of the harvest This is an example of moving income from one tax year to another to take advantage of lower marginal tax rates “Mortgage accelerator” strategy    Interest incurred on a loan to buy into an agribusiness scheme is usually tax deductible If you have non-deductible debts their after tax cost can be nearly twice as much as deductible debts, for an investor paying the 48.5% marginal tax rate 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 The after tax interest bill is basically the same as before except now you have an agribusiness investment and future cash flow advantages Dodgy schemes and the ATO     “Tax effective” investments have become notorious in the last few years following a widely publicised crackdown by the Australian Tax Office (ATO) Many schemes were put together by accountants and lawyers purely for the tax deductions 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, the crop was just a sideshow Far greater effort was put into finding ways to increase the tax deductions than to research the commercial viability of the crop Result: too many tea trees were planted, the price of tea tree oil fell below harvest and extraction costs, some blue gum plantations were made on cheap marginal land where the trees didn’t grow well Many other crops simply failed to meet prospectus projections The ATO cracked down on these, and disallowed tax deductions 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 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 By claiming a few tax deductions they may be able to reduce their adjusted taxable income to below the $99,710 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 If your income is not too far above the upper surcharge threshold and you are putting a lot of money into super, 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 Timing and netting of capital gains    If you can hold on to your taxable capital gains as long as possible, you will obtain a benefit by having that money invested in the markets Effectively an unrealised capital gain contains an “interest free loan” from the Australian Tax Office The longer you get to hold on to that gain, the longer you’ll be able to earn dividends and further growth on that money Therefore, methods that delay the realisation of capital gains tax can produce significant benefits Netting capital gains     If you sell an asset at a capital loss, you can only offset that loss against a capital gain Generally, you can’t claim a capital loss as a direct tax deduction Capital loss credits can be carried forward as long as is necessary for them to be used up Capital gains and losses are “netted” Each year you pay capital gains tax on the total capital gains minus the total capital losses While it is sensible to defer the realisation of capital gains, the same can not be said of capital losses In fact, a capital loss is a valuable asset for tax planning purposes and if possible should be realised 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 If you still like that particular asset, you could buy it back a short time later Deductible superannuation contributions      Employees can’t claim a tax deduction on their personal contributions, they must use salary sacrifice If you are self employed, or “unsupported”, you may be able to claim a tax deduction on some or all of your superannuation contributions A common post-retirement strategy is for people to liquidate their ordinary investment portfolio and claim a tax deduction on contributions to superannuation, to eliminate their capital gains tax liabilities 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, there are a variety of tests of age and employment activity       Superannuation co-contributions This year a new incentive was introduced to encourage lower income taxpayers to make voluntary contributions to their super This scheme is called the “co-contribution”, and involves the government matching your contributions up to a maximum of $1,500pa The amount of the co-contribution depends on your taxable income, and is at a maximum for people with income and reportable fringe benefits below $28,000, reducing by 5c in the dollar as your income exceeds this, cutting out at $58,000 Co-contribution = the lesser of your voluntary contribution and $1,500 – 0.05 x ($income&FB - $28,000) If the formula gives rise to a number below $20, the tax office will pay $20 The obvious beneficiaries would be lower income employees, but the main beneficiaries are likely to be part-time working spouses and semi-retired people Co-contributions replace the old $100 super contributions rebate Obviously this benefit is a lot more generous than the one it replaces One possible downside of tax planning    Before implementing any tax planning strategy, you need to consider the costs of doing so Such costs include accounting, 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 (Especially when creating tax structures like companies and trusts.) On the other hand, there are a number of simple strategies that can be relatively easily and cheaply implemented    Summary There exist legal and acceptable methods for reducing tax, but tax planning should only ever be of secondary importance behind wealth/retirement planning Some tax planning methods are very powerful, a combination of negative gearing, salary packaging and agribusiness can reduce the amount of tax paid to very low levels, but sometimes just taking the money and paying income tax on it is the better long term strategy An accountant and a financial planner can assist in implementing all of the strategies mentioned here, plus many others Disclaimer: The material in this presentation does not represent a recommendation of any particular security, strategy or investment product The author's opinions are subject to change without notice Information contained herein has been obtained from sources believed to be reliable, 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 Investors should seek the advice of their own qualified advisor before investing in any securities [...]... The three tax systems of Australia     Personal income is taxed in Australia on a marginal tax rate system The higher your income, the higher the average rate of tax you pay 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% No discounts apply to capital gains Superannuation funds pay tax of... Companies are distinct tax entities recognised by the Tax Office, and can retain income and assets in their own name and need to lodge their own tax returns A common tax planning strategy is to retain and reinvest income in a company, only drawing a dividend when the shareholder’s tax bracket equals 30% or less Companies can be used as an efficient “parking” vehicle to defer personal income tax Trusts and... $70,000 plus * Medicare levy of 1.5% may also apply Personal tax system cont’d     Contrary to what many people think, your marginal tax rate is not equal to your average tax rate For example, if your income is $80,000, you will be on the top marginal tax rate Including Medicare Levy, the marginal tax rate of such a taxpayer is 48.5% The amount of tax actually paid by someone earning $80,000 is $24,512... super which are all taxed differently (we’ll gloss over the complexities in this presentation), the most common components are “Pre 83”, “Post 83” and “Undeducted” 5% of Pre 83 money withdrawn from a super fund is taxed at marginal tax rates 95% is tax free In the 2004/05 tax year, you can withdraw $123,808 of “post 83” money from a superannuation fund before having to pay any tax on this lump sum... withdrawals is taxed at 15% (+ 1.5% Medicare), subject to reasonable benefits limits Undeducted components can be withdrawn from super tax free Pre and Post 83 untaxed amounts withdrawn in excess of your reasonable benefit limit are taxed at 47% plus Medicare, post 83 taxed amounts drawn as a lump sum in excess of your RBL are taxed at 38% Withdrawing from super – income streams    Income streams are taxed... excess of the Reasonable Benefits Limit is taxed at normal marginal tax rates, but doesn’t attract the 15% pension tax offset Superannuation contributions surcharge    If your “adjusted taxable income” (ATI) exceeds certain thresholds, an additional tax is paid on contributions to superannuation This tax does not affect earnings, just contributions Adjusted taxable income is your total remuneration,... advisor can be of assistance 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, Senior Australian’s Tax Offset, spouse superannuation contributions offset, personal super contributions offset, dependent spouse offset, family tax benefits part A and B,... someone earning $80,000 is $24,512 including Medicare Levy This works out to an effective tax rate of about 31% The top marginal tax rate only applies on the last $10,000 of income, though of course any additional income would be taxed at 48.5% and most tax planning that we do will be on dollars that would be taxed at the highest rate For long term capital gains (asset held more than one year), the... distributions and offer significant tax planning opportunities Beneficiaries of trusts can be people, companies, partnerships and other trusts 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 You only pay 15% tax on income in a super fund and the capital gains tax rate on assets held for... gains A surcharge may also apply for contributions for high income earners Arguably GST is counted as a fourth tax system, but is outside the scope of this discussion as it has limited applicability to investment strategies Personal tax rates for Australian residents 2004/2005 Taxable income Tax payable* $0 to $6,000 Nil $6,001 to $21,600 $0 + 17% of excess over $6,000 $2,652 + 30% of excess over $21,600 ... 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... high rate of tax to an entity paying a lower rate of tax Strategies for moving profits and losses between tax years, either to defer tax or take advantage of a more favourable tax rate Strategies. .. obtain a tax deduction, including trying to minimise their income Minimising your income is silly, what you want to is increase your assets and/or after tax income Some popular tax planning strategies