Testamentary trusts: Changes to taxing of distributions to minors

Income splitting is a tax reduction strategy which often involves one family member, who earns greater income (and is therefore in a higher income tax bracket), "splitting" off their income to a spouse or child in a lower income tax bracket.

Various tax integrity provisions already exist in the tax law which prevent this practice, as this is regarded as an inappropriate means of obtaining beneficial tax treatment. The Treasury Laws Amendment (2019 Measures No 3) Bill 2019 introduces a further measure which trustees of testamentary trusts should be cognisant of when distributing to minors.

How are distributions to minor from a discretionary trust normally taxed?

Distributions of passive income to certain minors from discretionary trusts are subject to a higher tax rate (generally the top marginal rate for individuals).

The policy reason for this is to discourage the diversion of income away from a higher income earning adult beneficiary, and there are limited exceptions - for instance for minors who work full time.

How are distributions from a testamentary trust to a minor taxed under the current law?

Section 102AG of the Income Tax Assessment Act 1936 (Act) allows for prescribed persons" who receive income generated from the assets of a deceased estate to have that income assessed at their applicable marginal rate (as opposed to the highest marginal rate). This income is known as excepted income" in the Act.

What is the issue that the new laws are trying to address?

The exception at section 102AG of the Act has led to the practice of injecting" assets from a discretionary trust into a testamentary trust, the subsequent profits of which are distributed out to a minor who has the benefit of being assessed at their marginal tax rate. In this way, discretionary trusts can avoid having the minor assessed at the highest tax rate, by distributing assets to the testamentary trust, with the testamentary trust distributing profits from those assets as "excepted income".

Here?s how it would work in practice:

• For example, a testamentary trust is established under a will and pursuant to the will $100,000 cash is transferred to the trustee from the estate of the deceased.
• One of the beneficiaries under the testamentary trust is under the age of 18 and is not an "excepted person" within the meaning of section 102AC(2) of the Act.
• A related family trust then distributes $1,000,000 to the testamentary trust.
• Up until 1 July 2019, the interest on the full sum of $1,100,000 could have been distributed out to the minor and the minor would have been assessed at their applicable marginal tax rate.
• Additionally, the full $1,100,000 could have been invested into shares by the testamentary trust, with the resulting dividends distributed out to the minor. The minor would have then been assessed at their applicable marginal tax rate.

This practice was regarded as artificially inflating the corpus of the testamentary trust in order to get the benefit of "excepted income" pursuant to section 102AG of the Act.

How does the proposed new law work?

The Treasury Laws Amendment (2019 Measures No 3) Bill 2019 (Bill) which is making its way through federal Parliament, includes further measures to address certain income splitting schemes.

From 1 July 2019, minors will no longer be taxed at normal marginal rates for income generated from assets which are unrelated to a deceased estate, i.e. assets which have been injected into the trust, nor income generated from disposal of these assets.

This is achieved by amending division 6AA of the Act and section 13 of the Income Tax Rates Act 1986. In particular, the Bill limits the extent to which income is excepted such that in order for income to be excepted under paragraph 102AG(2)(a) of the Act:

• the assessable income must be derived by the trustee of the testamentary trust from property; and
• the property must satisfy any of three specific requirements which are aimed at ensuring a connection between the property and the deceased estate.

What are these new requirements for trust property?

Those three requirements are as follows:

• the property must have been transferred to the testamentary trust as a result of a will, codicil, intestacy or order of a court;
• the property represents accumulations of income or capital from property which satisfies the first requirement (e.g. additional shares which have resulted from a dividend reinvestment policy from shares that were originally transferred to the testamentary trust as a result of a will); or
• the property represents accumulations of income or capital from property which satisfies the second requirement or this requirement (e.g. further shares which have resulted from new shares from the original dividend reinvestment policy).

What is the practical effect of the proposed new law?

These measures ensure that only income from assets which have organically accumulated within the corpus of the testamentary trust can be excepted trust income in the hands of a receiving "prescribed person". Where funds have been injected post-1 July 2019, and all the funds of the testamentary trust have subsequently been invested in income-producing assets, the tax treatments of the income from those assets will be apportioned accordingly.

The changes will apply retrospectively in relation to assets acquired by or transferred to the trustee of the trust on or after 1 July 2019. The changes should be noted by customers who are considering ordering a "Will with a Testamentary Trust" offered through Cleardocs.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Revenue Practice Group.

More Cleardocs information on related topics

You can read earlier ClearLaw article on a range of matters.