Tax-effective Investing – Alternative Structures

Most investors consider superannuation for long term tax-effective savings. Both the Government and the Opposition are now targeting its concessions away from wealth creation and estate planning.  Investors seeking greater certainty and more flexibility may look outside of superannuation to build wealth, plan for various life events (including enhanced retirement living) and to implement appropriate estate planning strategies (including inter-generational wealth transfers). 

So what other investment structures should investors consider?

Companies and investment bonds are both potential alternative investment structures, where income can be earned limiting the tax rate to 30% (currently). However, investment bonds have some unique features that in certain circumstances may give them an edge over company structures.

Company structures may suit high net wealth 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 may 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 offer an alternative long-term strategy given that personal tax relief becomes permanent after 10 years1.

Let’s take a closer look at how these two alternatives outside of superannuation compare and the benefits of each option.

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Generally, individuals on higher marginal tax rates may seek tax-effective investments that achieve long term wealth creation over and above their superannuation, which is now limited by policy-driven contribution caps.

As an investment vehicle for tax-effective wealth creation, Centuria Investment Bonds are an alternative option to a Company Structure. However, from a tax strategy point of view, there is a fundamental difference between these two options.

*Assuming the 125% rule on deposits is not broken and withdrawals are not made within the first 10 years.

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 Portfolio, not by the investor. So, there is no notional gross-up 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.

Side by Side

Feature Investment Bond Investing via Structure Company
1 Entity Tax Rate

Whether on income or capital gains

30% 30%
2 Personal Tax Rate

When entity income is distributed on an on-going 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

– Death or disability of life insured

– Unforeseen serious financial difficulties of bond investor.

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).

3 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.

4 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.
5 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
6 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).
7 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).

1. If bond is withdrawn (or part-withdrawn) during first 8 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 bond is withdrawn (or part-withdrawn) in 9th year, the amount personally taxed is 2/3rd (with 1/3rd being tax-free). If bond is withdrawn (or part-withdrawn) in 10th year, the amount personally taxed is 1/3rd (with 2/3rd being tax-free).

2. The ‘life insured’ can be any natural person(s) nominated by the bond 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.

Centuria’s Investment Bonds offer 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 Investment Bond will depend on a person’s circumstances, financial objectives and needs, none of which have been taken into consideration in this advertisement. 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’s Investment Bonds. Investment in Centuria’s Investment Bonds are subject to risk as detailed in the PDS. Centuria will receive fees in relation to an investment in its Investment Bonds. Issued by Centuria Life Limited ABN 79 087 649 054 AFSL 230867.