New law closes loophole on favourable tax treatment of income from testamentary trusts.
Testamentary trusts are trusts created by the testator under the will to be established upon the death of the testator. These trusts provide benefits such as asset protection (i.e. to protect a beneficiary who is prone to potential liabilities and matrimonial disputes) and tax concessions.
Generally minor beneficiaries are taxed at the highest marginal tax rates ("penalty rates") for distributions of income by trusts received by them. This is to prevent adults with higher income from diverting their income to minors who normally would have the benefit of the income tax threshold were it not for the scheme.
However if the minor beneficiaries receive income distributed by a testamentary trust (or trust estate resulting from a will, codicil, intestacy or court order varying a will, codicil or application for intestacy in relation to the estate of a deceased person), they are taxed at marginal tax rates ("concessional tax rates").
A loophole often used to avoid incurring the penalty rates is for a related trust to distribute its income to the testamentary trust which the latter ultimately distributes to the minor beneficiary. That is because under the previous law it was uncertain whether the property of a testamentary trust had to come from a deceased estate to enjoy the concessional tax rates.
Changes Introduced by the New Law
On 23 June 2020 a new law was passed to plug this loophole by adding new requirements for income distributed by testamentary trusts to enjoy concessional tax rates. The law aims to prevent the practice of injecting property which is unrelated to the deceased estate into the testamentary trust and generating income subject to concessional tax rates (if received by a minor beneficiary).
For income distributed to the minor beneficiaries to be taxed at concessional tax rates, the new law requires that starting 1 July 2019 the property generating the income must be transferred:
- to the trustee of the testamentary trust to benefit the beneficiary;
- from the deceased estate; and
- as a result of the will, codicil, intestacy or court order varying a will, codicil or application for intestacy in relation to the estate of a deceased person.
Accumulations of income or capital from the property described above (and subsequent accumulations of income or capital from the latter property) when received by minor beneficiaries are also taxed at concessional tax rates under the new law.
- A testamentary trust was established by will upon the death of Mr X.
- A minor is a beneficiary of both a family trust and a testamentary trust.
- The testamentary trust is also a beneficiary of the family trust.
- The family trust earns income of $60,000 which is distributed to the minor beneficiary. The income received by the minor beneficiary will be subject to the penalty tax rates.
- The testamentary trust has $40,000 transferred from the deceased estate of Mr X which was distributed to the minor beneficiary. The income received by the minor beneficiary will be subject to the concessional tax rates.
- Loophole: Before 1 July 2019 the family trust could distribute $60,000 to the testamentary trust giving the latter a total of $100,000 to distribute to the minor beneficiary. This $100,000 income received by the minor beneficiary used to be taxed at the concessional tax rates.
- New Law: The $100,000 income received by the minor beneficiary from the testamentary trust will be taxed as follows:
- $60,000 will be taxed at the penalty rates as it is unrelated to the deceased estate of Mr X (i.e. it originated from the family trust).
- $40,000 will remain taxed at the concessional tax rates as it is generated by a property coming from the deceased estate.
- If the $100,000 was instead invested by the testamentary trust in a property which generated an income of $10,000 and eventually distributed to the minor beneficiary, the $10,000 income will be taxed as follows:
- $6,000 will be taxed at the penalty rates as it is income generated by a property 60% of which was purchased using income originating from the family trust (i.e. unrelated to the deceased estate of Mr X).
- $4,000 will remain taxed at the concessional tax rates as it is income generated by a property 40% of which was purchased using income coming from the deceased estate of Mr X.
Individuals who have already executed their wills with testamentary trust provisions may need to assess whether the new law changes their estate planning outcomes and seek professional assistance to review their wills and change their estate planning strategies if so.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.