In this newsletter, newsletter, we continue to outline some of the unique and varied taxation consequences associated with testamentary trusts, not surprisingly many of which are not well understood or identified by many accounting or legal practitioners.
- It may be necessary for a trustee of a testamentary trust to consider making a ‘Family Trust Election’ when a beneficiary of a trust personally has combined franking credits that would exceed $5,000 per annum, including those distributed from the testamentary trust. Without this election, the trustee is unable to pass on the franking credits from the trust to that beneficiary as it is unable to pass the “holding period” rules. There are a number of serious considerations and consequences that need to be assessed prior to making such an election. For further information refer to our podcast on this topic.
- A trustee can elect to be taxed on any capital gains derived by the trust, but this election must be in writing as per section 115-230 of the ITAA 1997. This provides a fair and equitable outcome where an income beneficiary is not entitled to a share in the capital of the trust, and without an election, that income beneficiary would be taxed on a capital gain whilst the underlying benefit from the gain would ultimately only pass to the remainder beneficiary.
- Where a CGT event can however be directly attributable to a beneficiary and that beneficiary receives the proceeds of that event, they will then be deemed presently entitled to the extent of that gain which will be taxed in their hands accordingly.
- A trustee is liable to pay tax on the share of trust income on behalf of a non-resident beneficiary who is presently entitled to income that is attributable to Australian sources. The amount payable will vary and will be dependent upon the type of income being earned, and what tax treaties Australia has in place with the country of residence of the beneficiary.
TFN withholding rules
Since 1 July 2010, the ATO has required that trustees collect and report the tax file number (TFN) of beneficiaries of closely held trusts, or where they are unable to obtain these, to withhold amounts from these entitlements and remit this amount to the ATO.
These rules also apply to any deceased estate that is still operating after five years from the date of death of the deceased, and importantly from the commencement of any testamentary trust, where there is a beneficiary that is presently entitled to any trust income. It is important to note that these rules do not apply where there are beneficiaries who are tax exempt, or whose tax liability is assessed against the trustee eg minors and non-resident beneficiaries.
Impact on trustee
- The trustee must collect the TFN for all beneficiaries. These must be reported to the ATO via a TFN Report in the quarter that the TFN’s are obtained but are only required to be reported once.
- Where no TFN is obtained, tax must be withheld at the highest marginal tax rate (currently 47%).
- The trustee has an obligation to also provide an annual PAYG withholding summary to any beneficiary for whom tax has been withheld.
Impact on beneficiaries
- Beneficiaries who are also pensioners receiving tax exempt pensions are not immune from these rules. Pensioners must quote their personal TFN to the trustee to avoid having amounts withheld from payments by the trustee. This is at odds to the current practice of pensioners being able to quote an exempt TFN to investment bodies like a financial institution or Centrelink.
- Accordingly, it may be necessary for beneficiaries to physically apply for their first TFN. We see this frequently with widows whose primary role has been that of a housewife or carer and have never needed to obtain a TFN.
- A beneficiary who does have tax withheld from their payment would be entitled to a tax credit for this amount when they lodge their income tax return for the given year.
It should be noted, that the obligation to withhold tax is when a distribution is made, or when a beneficiary becomes presently entitled to trust income (even if it has not been physically distributed to them). The failure of a trustee to meet this obligation will impose a number of administrative penalties against the trustee, as well an obligation to still remit the tax that should have otherwise been withheld.
Pay or notify rule
Effective from 29th June 2011, subsection 100AA(3) of the ITAA 1936 treats a tax exempt beneficiary as not being presently entitled to the income if the trustee failed to notify or pay the tax exempt beneficiary of their entitled amount within two months of the end of the relevant income year. If the pay or notify rule applies, the exempt beneficiary is treated as not presently entitled to the income of the trust, and the trustee is taxed on that respective share of the income.
However, subsection 100AA (4) of the ITAA 1936 provides the Commissioner with the discretion to not apply the rule when the trustee fails to notify or pay in time. In exercising this discretion, the Commissioner considers the following factors:
- Circumstances that led to the trustee failing to notify or pay the amount within two months of the year.
- The extent to which the trustee has taken actions to try to correct the failure and how quickly those actions were taken.
- Whether the trustee has applied to the Commissioner to exercise his discretion previously.
- Any other relevant matters.
A trustee of a testamentary trust can inadvertently trigger the pay or notify rule when the trust vests. For example, on the death of the life tenant, and the trustee was not able to notify the tax exempt remainder beneficiaries of their entitled amounts within the two month period after the end of the financial year.
Trustee distribution resolutions
Since 2012, the ATO has been active in reviewing copies of distribution resolutions of discretionary trusts to ensure that they are effective and made before 30th June or an earlier date specified in the deed. Discretionary testamentary trusts will also be affected by this ATO administrative procedure.
If a valid resolution distributing the trust’s income is not made by 30th June, any later resolution will be ineffective and either the trustee or the default beneficiary will be made presently entitled to the income.
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.