Advisers pay less tax on commission income under LIF

The LIF reforms are bad news for advisers. The two-year clawback, high lapse rates and the time value of money mean most risk advisers will be worse off.

One person’s income is another person’s cost and the drop in advisers’ commission income will be matched by an equal drop in the insurers’ commission costs. This will result in a straight transfer of profit from advisers to insurers.

Although, if pushed to identify one good thing about the LIF reforms, I would say that the increase in renewal commissions from approximately 10 per cent to 20 per cent means many one-person risk practices will pay less tax on their commission income than otherwise might be the case. This is good news for one-person risk practices, provided they are structured correctly.

The rules for taxing commission income earned by one-person risk practices

One-person practices are not businesses for income tax purposes. Initial upfront commissions are personal services income under the general law, and are taxed in the hands of the person who generated the commission, that being the adviser.

Renewal commissions are different. They are not personal services income. They attach to the register, are connected to past personal efforts and are not dependant on future personal efforts. As a result, renewal commissions do not have to be taxed in the adviser’s hands.

If the practice, including the register, is owned and operated by a family trust, the renewal commissions can be distributed to lower tax rate beneficiaries, for example, low or no income adult children, (non-pensioner) parents, or related companies and trusts.

The final tax bill then depends on the beneficiaries' overall tax profile, but in most cases less tax is paid.

In fact, the ATO accepts that a one-person risk practice can be owned by a family trust.

For example, in Private Binding Ruling 34668 2004 the ATO said in relation to being asked by a tied life insurance agent if he could “use a trust as a vehicle for splitting insurance commissions?”:

“In conclusion, some of the taxpayer's income as an insurance agent will be earned from new commissions and some will be earned from an insurance register asset. Income that is personal services income, i.e. mainly derived from the taxpayer's individual efforts and skills (such as new commissions), is subject to the alienation provisions and is assessable in the hands of the taxpayer unless operating a personal services business. Even where the entity qualifies as a personal services business, Part IVA of the ITAA 1936, as well as the view expressed in IT 2330, may apply to income splitting arrangements. In contrast, an insurance register can be assigned for income tax purposes to a trust where the rights to future renewal, CPI and/or orphan policy commissions [are] severable from the remainder of the agency agreement and the severed contractual right is founded on the provision of past consideration and not the future personal exertion of the agent.”

The ATO’s reference to Income Tax Ruling IT 2330 merits specific comment. The ATO effectively says for a one-person risk practice initial commissions are personal services income and must be taxed in the advisers’ hands under the general law, and cannot be alienated to anyone else. There is no doubt the ATO is correct. For a one-person practice. initial commissions are taxed in the hands of the adviser, ie, the person who provided the service. A one-person risk practice that is not doing this should seek expert legal advice as soon as possible.

And the upshot of this is?

The LIF reforms increase renewal commissions from 10 per cent to up to 20 per cent

The upshot is if a one-person risk practice is owned by a family trust, the trustee:

• Must distribute (net) initial commissions to the adviser, but;
• May distribute (net) renewal commissions to other lower tax rate beneficiaries.

A one-person practice owned and run by a family trust will be able to legitimately distribute twice as much net income to lower tax rate beneficiaries from 1 July.

For most this means less tax will be paid, although how much less depends on each family’s tax profile.

Terry McMaster is a director of dealer group Dover Financial Advisers