Reforms to tax concessions available to minors receiving income from testamentary trusts proposed by the 2018 Federal Budget (finally) received assent on 22 June 2020 with the passing of the Treasury Laws Amendment (2019 Measures No. 3) Bill 2019.

Quick refresh of the former law

Division 6AA of the Income Tax Assessment Act 1936 is an anti-avoidance provision designed to deter trustees of trusts from splitting income between minor children. Most forms of unearned income are caught by Division 6AA resulting in minors being slugged with a penalty tax rate of 66% for income between $417 - $1307 and 45% for income over $1,307[1]. The tax-free threshold is a mere $416[2].

However, unearned income derived from a testamentary trust is excepted from the grasp of Division 6AA. This is one of the most attractive features of a testamentary trust because a minor’s “excepted trust income” is taxed at adult marginal rates. This means each minor may avail themselves of the $18,200[3] tax free threshold and incremental adult marginal rates.

Under the former law, excepted trust income included income derived directly from assets of the deceased estate as well as assets injected into the testamentary trust after it was established (subject to anti-avoidance rules).

The new law

The new law effectively confines excepted trust income to income derived directly from assets of the deceased estate or where the origin can be traced back to an asset of the deceased estate. This suggests that assets of the testamentary trust can change in type or character and continue to be considered excepted trust income. For example – if $1 million of cash is transferred into a testamentary trust from the deceased estate and then invested in a share portfolio, the income earned on the dividends will be considered excepted trust income.

No longer will capital injections from outside the relevant deceased estate be considered excepted trust income. Where such outside capital injections take place, separate accounting records should be maintained. Taking the above example further – if an additional $2 million of cash is transferred into a testamentary trust from a family trust and then invested in a share portfolio, then the accounts of the testamentary trust will need to quarantine income earned from the $1 million investment and income earned from the $2 million investment and each may be taxed differently.

What’s important to note

The new law introduces two conditions to confine the origin of the income to an asset derived from the deceased estate (Origin Conditions) and two further conditions to confine tracing of the origin of the income.

One of the Origin Conditions requires the asset to be transferred to the testamentary trust “to benefit the beneficiary from the estate of the deceased person concerned, as a result of the will, codicil, intestacy or order of a court…”. This means two key things:

Firstly, the Explanatory Memorandum specifically states that this condition excludes classes of beneficiaries added to a testamentary trust after it is created. Such additional classes are not contended by the will maker and therefore, cannot meet the condition that the asset was transferred for the benefit of such beneficiary.

For example – the beneficiaries of the testamentary trust set out in the Will are the Primary Beneficiary, the Primary Beneficiaries’ issue and spouses of the Primary Beneficiaries and their issue.

Scenario 1

You are the Primary Beneficiary and plan to have a baby. This will likely not result in any change to the class of beneficiaries. Ordinarily, a definition of beneficiaries includes people in existence at the date of the deceased’s death and people who come into existence later and fall within that description of that class. Therefore, the baby will come under the class “issue of the Primary Beneficiary”.

Scenario 2 You are the Primary Beneficiary and wish to stream income to your family trust. Your family trust does not fall under the description of any class of beneficiary, so it would need to be added in order to facilitate streaming. This does result in an additional class of beneficiaries.

Adding an additional class of beneficiaries means that two separate accounting records will need to be maintained.

However, please note the terms of each testamentary trust are unique and there may be alternate approaches, so always seek legal and financial advice.

Secondly, the condition appears to specifically preclude more than one deceased estate contributing to the same testamentary trust.

For example – you and your partner wish to create mirror Wills. For simplicity, you want to establish one testamentary trust and when you each die, each of your respective estates will pass into the same testamentary trust.

In this example, the estate of the second to die will not be taxed as excepted trust income and, again, two separate accounting records should be kept.

Tax law is complex and you should speak to your legal advisor and accountant to better understand how the new law will affect any testamentary trust you wish to set up under your Will and/or any testamentary trust of which you are trustee or a beneficiary.