A testamentary trust is a trust created under an individual’s will following their death. They may be contrasted with inter vivos trusts, which are ordinary trusts created during the settlor’s lifetime.
Testamentary trusts may be:
- simple (for example, where the legal personal representative is to hold an asset for a minor beneficiary until they reach a specified age); or
- complex (for example, where an ordinary discretionary trust deed is essentially built into the testator’s will in order to govern the testamentary trust over its lifetime).
Like ordinary trusts, testamentary trusts may be:
- fixed; or
What are the benefits of a testamentary trust?
We will focus on discretionary testamentary trusts (DTT).
A DTT has all of the advantages of an ordinary discretionary trust, including:
- asset protection; and
- distribution flexibility from year to year.
Similarly, DTTs also share the same disadvantages of an ordinary discretionary trust, for example:
- in New South Wales, they are not eligible for the land tax-free threshold (therefore, they will pay land tax from the first $1 of value on land assets in the jurisdiction); and
- they will be subject to duty surcharge and/or land tax surcharge unless they specifically and irrevocably exclude foreign persons (as relevantly defined for present purposes) from the class of beneficiaries.
Note – In New South Wales, ad valorem duty and surcharge duty do not apply on the transfer of real property to a testamentary trust in accordance with the will itself, however, they may apply on future acquisitions of real property in the jurisdiction.
The major benefit of a DTT compared to an ordinary discretionary trust relates to the tax treatment of trust distributions in the hands of minor beneficiaries (that is, children under the age of 18 years).
Minor beneficiaries and distributions from ordinary discretionary trusts
Where an ordinary discretionary trust distributes trust income to a minor beneficiary, the beneficiary:
- has a tax-free threshold of only $416; and
- is taxed at punitive rates of up to 66%.
Minor beneficiaries and distributions from DTTs
Where a DTT distributes ‘excepted trust income’ to a minor beneficiary, the beneficiary:
- has an ordinary tax free threshold (currently $18,200); and
- is taxed at ordinary adult tax rates.
This allows parents to meet the cost of raising their children (e.g., school fees) from low-tax or no-tax income over the life of the trust (up to 80 years in most jurisdictions).
Excepted trust income includes assessable income of a trust estate that resulted from a will, provided that:
- the assessable income is derived by the trustee from property; and
- the property satisfies one of the following:
- it was transferred to the trust to benefit the beneficiary as a result of the will; or
- it represents accumulations of income or capital from property that satisfies the above; or
- it represents further accumulations of income or capital from property that satisfies the above.
The wording of the relevant legislation is interesting in the context of a DTT, that is:
- the relevant property must be transferred to the trustee for the benefit of a beneficiary; however,
- in relation to a discretionary trust, no beneficiary has any ‘interest’ in any trust income or capital (it is entirely at the trustee’s discretion from year to year in accordance with the trust deed).
However, the legislation provides that:
- where any property is transferred to the trustee of a DTT; and
- the trustee has discretion to pay or apply the income from the property to or for the benefit of:
- specified beneficiaries; or
- beneficiaries within a specified class,
that property is taken to have been transferred to the trustee for the benefit of each of those specified beneficiaries or each beneficiary within the specified class for present purposes.
Legislative changes to combat ‘trust stuffing’
Traditionally, the tax law operated such that any income from a testamentary trust gave rise to excepted trust income, even income derived from non-estate assets subsequently settled on the testamentary trust.
However, to circumvent this practice (known as ‘trust stuffing’), the tax law was amended so as to limit excepted trust income to income derived from:
- estate assets; and
- the accumulation of income or capital (see above).
Impact of borrowing in a testamentary trust
Although the ATO does not have a formal ruling on its view as to the scope and operation of the trust stuffing amendments, informal guidance states that income derived from geared investments must be apportioned as between:
- excepted trust income – subject to concessional tax treatment in the hands of a minor beneficiary; and
- ordinary trust income – subject to punitive tax treatment in the hands of a minor beneficiary.
Therefore, the ATO does not accept that income generated from borrowed funds by a testamentary trust generate excepted trust income notwithstanding that:
- case law confirms that this was not previously an issue (see The Trustee for the Estate of the Late AW Furse No 5 Will Trust v FCT (1990) 21 ATR 1123); and
- the trust stuffing amendment, neither on their face nor in the explanatory materials make any reference, let alone prohibitions in this regard.
The ATO’s strict view as to the impact of borrowing by a testamentary trust needs at least judicial, but preferably legislative guidance.
What about reimbursement agreement issues?
In recent years, the ATO’s position as to the operation of the reimbursement agreement provisions has changed dramatically.
The reimbursement agreement rules are an anti-avoidance regime aimed at arrangements under which a beneficiary is made presently entitled to trust income and:
- someone other than that beneficiary receives a benefit in connection with the arrangement; and
- at least one of the parties enters into the agreement for a purpose of reducing tax.
However, if the relevant trust income to which the minor beneficiary is presently entitled is directly expended by the trustee on their behalf, for example, the payment of school/university fees, there is no payment of money, transfer of property, provision of services or other benefits to anyone other than the beneficiary such that the arrangement should not, without more, constitute a reimbursement agreement.
A DTT provides all of the benefits of an ordinary discretionary trust in addition to the ability to distribute to minor beneficiaries in a low-tax or no-tax manner.
The use of testamentary trusts should be canvassed as part of your estate and succession planning process.
For individuals with two or more children, you may also wish to consider whether it is appropriate to have:
- a single DTT for all of your children (which would generally be controlled together with the aid of a Shareholders Agreement in relation to the corporate trustee or a Deed of Family Arrangement as to the governance of the DTT and the corporate trustee going forward); or
- separate DTTs for each of your children (each holding discrete assets) such that each of them can operate their affairs completely independently of the others going forward.
The trust stuffing amendments, whilst understandable, will make no difference for those able to leave significant assets to one or more testamentary trusts.
Mosaic Tax Legal assists both:
- other law firms;
- accounting firms; and
financial planning firms,
on a trusted adviser or white-label basis to deliver tax advice across multiple industries on a State, federal and international basis.
We also provide direct-client services.
If you or your clients have any questions on the tax and duty issues relating to estate and succession planning generally, or testamentary trusts specifically, please feel free to contact our office.