|FUNDAMENTAL DIFFERENCES FROM A TAX STRATEGY PERSPECTIVE
INVESTING VIA A COMPANY STRUCTURE
While earnings remain within the company:
- Company structures are usually a tax deferral mechanism, therefore are not a tax effective solution if they do not actually reduce the eventual tax.
- Earnings on the funds are currently taxed at the company rate of 30%, while the funds are held within the company. This also assumes the anti-avoidance ‘personal services income’ rules do not cause the use of a company structure to become invalid for tax purposes.
Upon withdrawal or distribution of earnings:
- When company profits are withdrawn, they are normally treated as a dividend payment, which must be included in the investor’s assessable income.
- In the case of a private company, company profits can also be transferred to an individual as salary/wages, director’s fees, or interest on any loans advanced to the company, etc. Such transferred amounts can be expected to be included in the investor’s assessable income.
- Any distributed company profits are taxed at the investor’s marginal tax rate, less any franking credits. Any tax offset for franking credits merely compensates for taxed company profits – so the value of franking credits should be regarded as merely avoiding double-taxation.
- Tax is only reduced (on distributed company profits) if the investor’s marginal tax rate is lower in the tax year of withdrawal, than in previous years. Conversely, tax can be increased if the opposite were true.
- Also, tax is only reduced (on distributed company profits to an Australian tax resident) if the investor’s marginal tax rate is lower than the company tax rate. Again, conversely, tax can be increased if the opposite were true.
Upon sale of investor’s share interest:
- Lower tax can also be achieved, if the investor’s share interest is sold for a capital gain (after holding that interest for at least 1 year) and if 50% of the ‘discounted capital gain’ became exempt from tax. However, unless no other income amounts were drawn from the company, any discounted capital gains tax would be additional to full tax at marginal rates on such other income drawn from the company – including dividends and undiscounted capital gains.
- Conversely, if the investor’s share interest is sold for a capital loss, such a loss can only be offset against any current or future capital gains, and is not deductible against ordinary assessable income. If a capital loss is never offset, its tax benefit is lost permanently. Also, if a capital loss is offset under the discounted mechanism, its tax benefit is effectively halved.
Note: Use of a private company structure also needs to recognise the tax pitfalls of Division 7A of the Income Tax Assessment Act 1936. Division 7A may apply to a private company that makes tax-free distributions to its shareholders or their associates in the form of payments, loans or debts forgiven.
Tip: Investing money via a company structure may only defer tax payable. The earnings are still taxable at the investor’s marginal tax rate upon withdrawal. Tax is only reduced if the investor’s marginal rate has fallen at that point.
INVESTING INTO AN INVESTMENT BOND
Taxation within the first 10 years:
- During the period of investment, ongoing earnings are taxed within the bond, currently at 30%. They are not included as income of the investor and therefore do not increase the investor’s taxable income, or attract (or increase) the investor’s marginal tax rate.
- If the investment is held for at least 10 years, none of the withdrawn earnings will be included in the investor’s assessable income.
- Thus, tax on investment earnings can be permanently capped at 30%, and never attract personal tax (or Medicare levy).
- With a few exceptions*, the earnings component of withdrawals within the first 10 years must be included in the investor’s assessable income, however a 30% tax credit is then applied – to offset the impact of tax already paid in the bond.
- Only the net after-tax income received from the investment is taxable and is paid by Centuria from earnings of the 7 8 Autumn 2018 Portfolio, not by the investor. So, there is no notional grossup of assessable income for the investor here (unlike a franked dividend on a company share investment).
*Exceptions to tax on withdrawals within the first 10 years
- If a withdrawal is made in the 9th or 10th years, only a portion of the earnings is included in the investor’s tax returns.
- If funds are withdrawn at any time (even within the first 10 years) due to special circumstances, such as death, disability or serious illness of the bond’s nominated life insured (which can be the investor or another person), neither the investor nor the investor’s estate will pay any further tax.
- Similarly, if funds are withdrawn at any time (even within the first 10 years) due to unforeseen serious financial difficulties affecting the investor, no further tax is payable by the investor.
Nominated beneficiary’s taxation:
- A nominated beneficiary (who receives fund proceeds if the investor has died) will not be taxed.
As a long term strategy for tax-effective wealth creation, an investment bond may be an appropriate vehicle given there could be no personal tax obligations on reporting and payment by the investor.
Tip: Investment bonds offer a tax-effective savings solution for middle to high income earners, especially if funds remain invested for at least 10 years. A real tax saving occurs if the investor’s marginal tax rate is greater than the bond tax rate (of 30%) – as is the case with most working Australians on marginal tax rates of 34.5%, 39% and 49%. This can also apply to minors, who attract high tax rates (between 45% and 66%) on Division 6AA income above the small $416 tax-free threshold.
Investment bonds can also provide a tax advantage when compared to a company structure as the bond tax offset (unlike imputation credits from franked dividends paid by a company) is not part of the gross-up tax rules – and required to be included in the investor’s taxable income.