Taxation of testamentary trusts – Part 1

This is the first of a two part series discussing the nuances of the taxation of testamentary trusts.

Current at 1 November 2021

Taxation of testamentary trusts – Part 1

This is the first of a two part series discussing the nuances of the taxation of testamentary trusts.

Current at 1 November 2021

As such a testamentary trust is a separate taxpayer to a deceased estate and is required to obtain its own tax file number (TFN). There is a practice by some of not applying for a separate TFN, but rather continuing to use the TFN of the deceased estate. It would be prudent to point out however, that among other issues this may be problematic to the trustee at a future date given that testamentary trusts are subject to the Medicare levy whereas deceased estates are not. The ATO does view this practice as tax avoidance by the trustees.

Technically the Division 128 CGT rollover relief allowing an asset to transfer between a deceased estate, the executor and beneficiaries without incurring a CGT event, does not specifically apply to the rollover of assets to a testamentary trust. The ATO has addressed this in their Practice Statement PSLA 2003/12 by stating that they will treat the rollover of assets to testamentary trust in the same manner as they currently treat deceased estates. The Commissioner recently made some minor adjustments to this statement and reconfirmed his commitment to the use of this administration practice. However, as with any ATO practice statement, it operates solely at the Commissioner’s discretion and could arguably be withdrawn at any time; albeit we believe at this time this is most unlikely to occur.

A brief outline of some of the taxation consequences for a testamentary trust are listed below:

  • The trustee will be assessed on any income of the trust to which there are no beneficiaries presently entitled.
  • A trustee of a trust such as an inter vivos trust is taxed at the highest marginal tax rate on any undistributed income – ie in 2018, this is 47% (section 99A of the ITAA 1936). With testamentary trusts the Commissioner has the discretion to apply section 99 rates of the ITAA 1936, which are essentially standard adult marginal rates excluding the tax free threshold of $18,200.

Section 99 Rates ITAA 1936

Taxable incomeTax payable
0 – $416Nil
$417 – $67050% of excess over $416
$671 – $37,000Entire amount from $0 taxed at 19%
$37,001 – $90,000$7,030 + 32.5% on excess over $37,000
$90,001 – $180,000$24,255 + 37% on excess over $90,000
$180,001 and over$57,555 + 45% on excess over $180,000

 

Note: Medicare levy is applicable for testamentary trusts at 2% on entire income but is not applicable to deceased estates.

  • Under section 99 ITAA 1936, the trustee is entitled to access the 50% CGT discount on the disposal of assets which have been held for a period of greater than 12 months. This is not available to trustees of most other types of trusts.
  • Beneficiaries will be taxed on income to which they are presently entitled as per section 97(1) ITAA 1936, unless they are under a legal disability. This is the case even if the income has not been physically paid to them. The trustee will still however need to prepare and lodge an annual income tax return.
  • Where there is a beneficiary under a legal disability, the trustee is required to pay tax on their behalf under section 98(1) ITAA 1936. As such, a separate tax assessment notice will be issued to the trustee for each and every beneficiary that is under a legal disability.
  • Under section 102AG (2)(a) ITAA 1936, income from a testamentary trust for children is classified as ‘excepted trust income’ and will accordingly be taxed at ordinary adult marginal rates against the trustee. This essentially provides minors with access to the $18,200 tax free threshold that they are not ordinarily able to access.
  • It is essential to note, that if a beneficiary under a legal disability has other income sources, they are required to declare all that income within a personal income tax return. This would include the income distributed from the testamentary trust on which as trustee has already paid tax. They will however be credited with the tax paid by the trustee on their behalf, section 100(2) ITAA 1936.
  • A trustee who is assessed on income on behalf of a beneficiary lacking legal capacity, is only able to utilise tax credits (ie franking credits) to the extent of any tax obligation relating to that income. To the extent that such credits exceed this obligation, the trustee is unable obtain a refund of those excess credits. In such a situation, it would be prudent for the taxpayer, or their legal guardian, to lodge a personal tax return to obtain these otherwise lost credits.

Example

The distribution below relates to a minor beneficiary of a Testamentary Trust:

Franked dividend$14,000
Franking credit$6,000
Grossed up taxable income$20,000
Tax payable$342
Less low income tax offset$342
Less franking credits
Estimated tax refund$6,000

 

    •  The trustee will be assessed on this income, although the low level tax offset is sufficient to offset this tax. However, the
      trustee is not able to obtain a refund of the unused franking credits. Sadly, the above excess credits of $6,000 are frequently
      overlooked and foregone.
    • From the ATO’s perspective, all tax obligations in relation to the trust income have been met.
    • The trustee should issue a beneficiary tax statement to the minor advising:
    • The income and franking credits that have been distributed to them
    • The amount of tax paid on their behalf by the trustee
    • That they should obtain independent tax advice
    • In this example, should the minor lodge an income tax return and have no other income, they would personally receive a refund
      of $6,000 from the unused franking credits.

 

Case study

This actual case study discusses the duties of a trustee of a testamentary trust and outlines the reporting and tax compliance requirements.

Tom died in 2015 and his Will instructed that a testamentary trust be set up and that it should vest in 2058. His Will gave the trustee; Wendy, the powers to accumulate or distribute the income or capital at her discretion. The assets at Tom’s death were a rental property in Brighton and cash. In 2016, Wendy decided to purchase some shares with the excess cash.

There are three beneficiaries of the Trust being their children, one of whom just 13 years old, a second adult Australian resident and the third adult residing in the UK for the past 20 years.

Due to Wendy’s lack of knowledge of her duties as a trustee of a testamentary trust, Wendy has not made any distributions or lodged any income tax returns for the trust. She consulted her family accountant Bob on the running and the tax implications of a testamentary trust. However, Bob is unfamiliar with this area of taxation and decided to refer her to BNR Partners (BNR) for specialised tax advice as this can be a complex area.

During the meeting, BNR identified the following issues and tax implications for her own and Bob’s future consideration.

1. Distribution minute required prior to 30 June

  • As Wendy did not make any distributions in past years or have valid distribution minutes, there is no beneficiary presently entitled to the income. Accordingly, the net income of the trust in the prior years will be taxed to the trustee.
  • Fortunately, the income in the trust is taxed at concessional rates rather than penalty rates of 47%.
  • Advised Wendy to make a valid distribution minute prior to 30 June of each year.

2. Income distribution to Jim who is classified as an Australian adult beneficiary

  • Wendy will need to collect Jim’s personal TFN for reporting purposes and report the TFN to the ATO within the reporting quarter.
  • If Jim does not provide his TFN, Wendy will need to register the trust for withholding tax and withhold 47% tax of any distributions made to him.

3. Income distribution to Jean who is classified as a minor beneficiary

  • There is no requirement for Jean to quote her TFN as she is a minor and the trustee will be paying tax on her behalf on income over the tax-free threshold.
  • Even though Jean is a minor, Jean can receive up to $18,200 of income from the testamentary trust without paying tax as the income is derived from an estate property.
  • However, any excess franking credits can only be refunded if Jean lodges an individual tax return.

4. Income distribution to Jack who is classified as a non-resident beneficiary

  • There is also no requirement for Jack to quote his TFN as he is a non-resident and the trustee will be paying tax on his behalf on any rental income distributed to him.
  • However, any investment income will be subject to non-resident withholding tax rates and franked amounts tax free.
  • Any capital gains distributed to Jack will not qualify for the 50% discount.

In this instance, by working with external professionals, BNR was able to quickly identify the issues and any corrective actions required.

 

Feel free to contact our team should you want to discuss this topic further and potentially have clients who may be in this situation.

 

 

This publication is not intended to be and should not be used as a substitute for taking taxation advice in any specific situation. The information in this publication may be subject to change as taxation, superannuation and related laws and practices alter frequently and without warning.  Neither BNR Partners Pty Ltd, our employees or agents are responsible for any errors or omissions or any actions taken or not taken on the basis of this publication.