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2018 Federal Budget - Taxation of Testamentary Trusts

The 2018 Federal Budget was handed down by the Treasurer Scott Morrison on 8 May 2018.  The 2018 Budget is widely seen as an “election budget” with a number of sweeteners in the form of tax cuts being proposed that will benefit lower to middle income earners with slightly delayed tax benefits for higher income earners and a return to surplus in the 2019/20 year.

One of the areas addressed in the Budget is an “integrity measure” in relation to the taxation of testamentary trusts.  An “integrity measure” is a measure that is designed to assist with the efficient and appropriate operation of an existing law rather than the introduction of an entirely new law or the abolition of an existing law.

Many readers will be aware of the estate planning benefits of testamentary trusts (simply being a trust created under the Will of a person).  Testamentary trusts are a critical part of many well structured estate plans because of the benefits that they offer to a family in terms of:

  • Protection of estate assets for the benefit of the generations of a family;

  • The ability to structure a set of rules around particular types of estate assets which can be useful for the succession planning for the family;

  • The financial benefits that exist by utilising an effective trust structure, including effective tax planning.

In short, while the measure announced in the Budget in relation to the taxation of testamentary trusts is very appropriate from a policy perspective, for the vast majority of families, it will have no adverse impact on the way in which testamentary trusts are used for effective estate and succession planning.

To briefly remind readers, under the Australian tax laws, “unearned income” of a minor (including distributions to a minor of trust income from a family trust or a discretionary trust) is subject to penalty tax rates of tax.  Under this penalty tax regime the tax-free threshold is only $416 with a flat rate of tax of 66% on additional income up to $1,307 and a flat rate of tax equal to the top marginal tax rate on amounts above $1,308.    

Subject to certain anti-avoidance rules that already exist in the tax laws these penalty rates of tax do not apply to income derived by a minor as a result of a distribution of income from a testamentary trust.  The income (known as “excepted trust income”) is an exception to the penalty tax regime and is taxed at the normal adult tax rates that exist from time to time.

In the Budget Papers the following measure was announced:

“From 1 July 2019, the concessional tax rates available for minors receiving income from testamentary trusts will be limited to income derived from assets that are transferred from the deceased estate or the proceeds of the disposal or investment of those assets.

Currently, income received by minors from testamentary trusts is taxed at normal adult rates rather than the higher tax rates that generally apply to minors. However, some taxpayers are able to inappropriately obtain the benefit of this lower tax rate by injecting assets unrelated to the deceased estate into the testamentary trust. This measure will clarify that minors will be taxed at adult marginal tax rates only in respect of income a testamentary trust generates from assets of the deceased estate (or the proceeds of the disposal or investment of these assets).

This measure is estimated to have a small unquantifiable gain to revenue over the forward estimates.”

This proposal is, in essence, an anti-avoidance measure that will ensure that the normal adult tax rates will only apply to testamentary trust income that is generated on assets that are deceased estate assets or income derived from assets that have their genesis from the deceased estate assets.  Assets that a family might own that are outside of the deceased estate and that are transferred to the testamentary trust will not generate “excepted trust income”, rather, this income will be subject to the penalty tax rates.  

In  many ways this measure seeks to make clear in the legislation what already exists in complex anti-avoidance rules. The Division 6AA of the Income Tax Assessment Act 1936 contains the provisions that impose the penalty tax regime referred to above and also contain the exceptions to those penalty taxes.  This Division already contains anti-avoidance rules that, in summary, apply the penalty tax regime to income derived by a minor beneficiary from a testamentary trust in circumstances where:

  • The income is derived from an arrangement or transaction that is not “arms length”; or

  • The income is derived from an arrangement that was entered into or carried out for a purpose of securing “excepted trust income” (ie the concessional tax treatment).  For the application of this anti-avoidance rule the ‘purpose test’ is not a ‘dominant purpose test’ but is merely an ‘anything but an incidental purpose test’ (ie a very low hurdle to trip over).      

The proposed amendment is, in our view, appropriate from a policy perspective to maintain the integrity of the tax system in ensuring that concession applies in the manner intended.  Importantly, the new measure will, hopefully, apply the law very clearly without having to rely on the application of the existing anti-avoidance rules which, like many tax laws, are complex in their application.    

For the vast majority of families, this Budget measure will have no impact whatsoever on the effective use of testamentary trusts for estate and succession planning because:

  • The existing anti-avoidance rules already deal with the mischief identified in the Budget announcement and, as a consequence, the vast majority of families do not use their testamentary trusts in a way that would cause any concerns for the Revenue Authorities; and

  • All of the other significant benefits of the testamentary trust structure including protection planning and achieving of longer term family objectives are not affected.

Interestingly also, with the proposed tax cuts announced in the Budget (both in the immediate term and the slightly longer term) the tax planning benefits arising from the proper use of testamentary trusts will only be enhanced.

If you have any questions in relation to this article or require any assistance in relation to your estate and succession planning please contact the authors or other members of the Private Client Group at Bartier Perry.

Authors: Andrew Frankland and Belinda Cao