Tax-effective investing strategy
Alternative structures for tax-effective investing
Investors seeking greater certainty and more flexibility with their investments may want to look outside of superannuation at different structures, such as investment bonds.
Many investors consider super for its long-term tax-effective savings. However, both the Federal Government and Opposition are targeting super’s concessions, which may affect wealth creation and estate planning.
Investors may want to look outside of super to build wealth, plan for various life events (including enhanced retirement living) and to implement appropriate estate planning strategies (including inter-generational wealth transfers).
What other structures should investors consider?
Generally, individuals on higher marginal tax rates seek tax-effective investments that achieve long-term wealth creation over and above their super, which is now limited by contribution caps.
Companies and investment bonds are two alternative investment structures, where income can be earned and the tax rate is limited to 30% (currently).
Company structures may suit high-net-worth clients who are happy to set up a private company to hold investments. But this may only be a tax-deferral mechanism as eventually funds need to be paid out of the company, and personal tax becomes payable at the investor’s marginal tax rate, less any franking credits (if an Australian tax resident).
Investment bonds have certain features, which in particular circumstances may give them an edge over a company structure, including permanent personal tax relief on any earnings after 10 years - assuming the 125% rule on deposits is not broken and withdrawals are not made within the first 10 years.
Let’s take a closer look at how these two alternatives outside of super compare and the benefits of each.
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- When company profits are withdrawn, they are normally treated as a dividend payment, which must be included in the investor’s assessable income.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. Such transferred amounts are 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 is 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 is true.
Upon sale of an 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 one 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.
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.
Investing using 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 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.
- Therefore, tax on investment earnings can be permanently capped at 30%, and never attract personal tax (or the 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 the portfolio’s earnings, not by the investor. So, there is no notional gross-up of assessable income for the investor (unlike a franked dividend on a company share investment).
- 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.
* Exceptions to tax on withdrawals within the first 10 years. If bond is withdrawn (or part-withdrawn) during first eight years, 70% of bond income (after 30% bond tax) is personally taxed – but a 30% tax offset automatically applies. So, of the total bond income, effectively 30% is taxed at 30% (at bond level), the balance is taxed at personal tax rates. No imputation-style gross-up occurs. If the bond is withdrawn (or part-withdrawn) in the 9th year, the amount personally taxed is 2/3rd (with 1/3rd being tax-free). If the bond is withdrawn (or part-withdrawn) in the 10th year, the amount personally taxed is 1/3rd (with 2/3rd being tax-free).
The ‘life insured’ can be any natural person(s) nominated by the investor, who is the default life insured (unless another person is nominated). The life insured has no interest in the bond, but whose death or disability can be a trigger point for a bond termination.
Side by side
|Feature||Investment Bond||Investing via Structure Company|
|Entity Tax Rate: Whether on income or capital gains||30%||30%|
|Personal Tax Rate: When entity income is distributed on an ongoing basis, such as dividends. When entity income is distributed upon a wind-up, effectively a final dividend.||No personal tax, if bond withdrawn (or part-withdrawn) after 10 years, or if withdrawn anytime due to: (a) Death or disability of life insured (b) Unforeseen serious financial difficulties of bond investor; the 30% tax rate cap remains.||30% replaced by personal tax at marginal tax rate (via operation of dividend imputation system). In effect, the 30% company tax rate is only temporary (or provisional).|
|Personal Tax Rate: on Capital Gains (only applicable when an individual's investment is disposed of)||Bond income is treated as ordinary income. No capital gains tax (CGT) reporting or compliance required.||Effective 50% tax reduction applies to discounted capital gains (on shares held for more than a year).Capital gains tax reporting or compliance required.|
|Investment Transfers: On Capital Gains (only applicable when an individual's investment is disposed of)||Bond assignment can be seamlessly made. Retains original start date. No personal tax event for transferor, if assignment is for nil consideration.||A share ownership transfer creates a CGT event, with personal tax consequences.|
|Bankruptcy Protection||Full protection from creditors, if nominated life insured is either the bond investor or investor's spouse. Protection extends also to future bond payout monies.||No protection from creditors|
|Nomination of Beneficiaries||If there is no separate life insured (to the investor), specific bond beneficiaries can be nominated, outside a Will, and may also be better quarantined from any Will contests.||Company share investment generally falls to be with part of a person's estate, and dealt with in terms of a Will (if one exists).|
|Investment Life after Death||If the life insured survives the bond investor, a bond can continue, and be held as an asset of the estate.||Generally no, as share investment has to be transferred (via the estate).|
Tax-effective investing: Alternative structures case study
Scenario 1 – Using a company structure for wealth creation
Julie establishes a private company in which she invests $120,000. The company invests in a range of investments and all earnings are retained within the company.
- After three years, the company declares a fully franked dividend of $36,000** and Julie withdraws the $120,000 invested.
- Julie is on a high marginal tax rate of 49% (45% plus 2% Medicare levy plus 2% temporary Budget Repair levy).
|Julie's tax position after receiving the dividend:|
|Fully franked dividend||$36,000|
|Franking credit ($36,000 x 30/70)||$15,429|
|Total included in taxable income ($36,000 + $15,429)||$51,429|
|Tax at 49%||$25,200|
|Less: franking credit||$15,429|
|Net tax payable ($25,200 - $15,429)||$9,771|
|Net earnings ($36,000 - $9,771)||$26,229|
Scenario 2 – Using Centuria LifeGoals for wealth creation
Jason places $120,000 into Centuria LifeGoals.
- After three years, Jason withdraws the investment of $120,000 plus all realised earnings amounting to $36,000.
- Jason is on a high marginal tax rate of 49%.
|Jason's tax position after receiving the dividend:|
|Growth portion (included in taxable income)||$36,000|
|Tax at 49%||$17,640|
|Less tax offset ($36,000 x 30%)||$10,800|
|Net tax ($17,640 - $10,800)||$6,840|
|Net earnings ($36,000 - $6,840)||$29,160|
Each investor includes their earnings in their tax return, however because only the net earnings received from Centuria LifeGoals are taxable, in the second scenario – Jason, who invested in bonds, pays $2,931 less tax than Julie, who invested in a company.
After 10 years
If Jason retained his investment within Centuria LifeGoals for at least 10 years (or received it under any of the special circumstances mentioned above), he would not pay any personal tax. Under these circumstances, Jason (or his estate, if he has passed away) receives a significant tax saving of $9,771 – compared to Julie who invested her money using a company structure.
** In this scenario it is assumed that the quantum of the franked dividend declared is the same as the level of franking within the selected investment option of Centuria LifeGoals. This example is purely for illustration purposes and gives no consideration to the underlying assets and the likelihood of the return. Investors should be mindful of the underlying assets into which each investment vehicle invests and, in particular, the income and capital gains or losses (and their taxation effects) that may be derived from those assets. These factors will impact on the franked dividend or investment bond growth at the end of the period.
Centuria LifeGoals offers a tax effective investment vehicle outside of superannuation. They have features that investors should consider if they wish to invest outside of superannuation. Suitability of an investment in a Centuria LifeGoals investment will depend on a person’s circumstances, financial objectives and needs, none of which have been taken into consideration in this case study. Prospective investors should obtain and read a copy of the Product Disclosure Statement (PDS) and consider the information in the PDS in light of their circumstances, objectives and needs before making a decision to invest. We recommend that prospective investors consult with their financial adviser. This document is not an offer to invest in any of Centuria LifeGoals Investment Options. Investment in Centuria LifeGoals is subject to risk as detailed in the PDS. Centuria Life will receive fees in relation to an investment in its Investment Options. Issued by Centuria Life Limited ABN 79 087 649 054 AFSL 230867.