The old ‘sledgehammer** to crack the nut’ trick ... Treasury finally releases excepted trust income and testamentary trust rule changes

The announcement in the 2018 Federal Budget that “the concessional tax rates available for minors receiving income from testamentary trusts will be limited to income derived from assets that are transferred from deceased estates or the proceeds of the disposal or investment of those assets” was for many a surprise.

As is usually the case with Budget announcements attacking perceived arbitrage revenue opportunities, the exact impact of the changes will revolve almost entirely around how the legislation is crafted.

Thus, as flagged in previous posts, advisers in the estate planning industry should likely continue to be concerned as to what the Government means by suggesting that the mischief to be addressed is “that some taxpayers are able to inappropriately obtain the benefit of (a) lower tax rate by injecting assets unrelated to the deceased estate into testamentary trusts.’’

In turn, the Budget statement that the “measure will clarify that minors will be taxed at adult marginal tax rates only in relation to income of a testamentary trust that is generated from assets of a deceased estate (or the proceeds of the disposal or investment of these assets)’’ also has the distinct prospect of having much wider consequences than might otherwise be expected.

In a similar vein however to the unfinalised trust splitting ruling, the significant delays in any further progress in this area is problematic.

Oher previous posts have explained that pursuant to Div 6AA of the ITAA 36 and, in particular, subs 102AG(2)(a)(i), excepted trust income is the amount which is assessable income of a trust estate that resulted from a will, codicil or court order varying a will or codicil.

Where income is excepted trust income and it is distributed to minors, those minors are taxed as adults, instead of the normal penalty rates that otherwise apply to unearned income.

Last week, the draft legislation implementing the 2018 Budget announcement was finally released for consultation.

With the unexplained retrospective effect from 1 July 2019, the new rules were crafted as follows:

“(2AA) For the purposes of paragraph (2)(a), assessable income of a trust estate is of a kind covered by this subsection if:

(a)         the assessable income is derived by the trustee of the trust estate from property; and

 (b)  the property satisfies any of the following requirements:

(i) the property was transferred to the trustee of the trust estate 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 mentioned in paragraph (2)(a);

(ii) the property, in the opinion of the Commissioner, represents accumulations of income or capital from property that satisfies the requirement in subparagraph (i);

(iii) the property, in the opinion of the Commissioner, represents accumulations of income or capital from property that satisfies the requirement in subparagraph (ii), or (because of a previous operation of this subparagraph) the requirement in this subparagraph.”

As seems to be increasingly the case, the proposed changes see a simple and discrete tax leakage issue on announcement, morph during the legislative drafting process into rules that will have far reaching implications.

Some of the key initial concerns with the draft legislation are as set out below.

1 The proposed amendments refer to property which was “transferred to the trustee of the trust estate…from the estate of a deceased person.” 

2 To the extent the trustee of the testamentary trust borrows money (or indeed assumes the borrowings the deceased was liable to at the date of death) to acquire assets, it appears that income from the assets acquired partially funded by debt would not qualify for excepted trust income treatment.

3 Similarly, where distributions are made by the trustee to a beneficiary and then lent back to the trustee, it seems unlikely the re-contributed amounts would qualify for excepted trust income.

4 The second and third limbs of the eligibility test in proposed s (2AA)(b) refer to “the opinion of the Commissioner.” 

5 In a self-assessment tax system, this approach creates significant uncertainty for the taxpayer and in turn tax professionals and also makes it almost impossible (at least until substantive case law is developed) for a taxpayer to challenge the Commissioner’s opinion, where they objectively believe the Commissioner has formed an incorrect or unjust opinion. 

6 In an area that already has substantial compliance costs, hardwiring subjective tests into the law guarantees further significant costs to taxpayers and indeed is likely to lead to increased administrative issues for the Commissioner.

7 Many testamentary trusts will exist for decades and the assets originally received from the deceased estate will inevitably be sold over time so the trust can re-invest in other assets. 

8 Under the proposed changes, a scenario is created where many trusts will be entirely dependent on the Commissioner forming a favourable opinion under the second and third limbs of the new legislation, despite not having taken any steps which could be considered inappropriate.

9 The legislation is focused on “the deceased person concerned” and it is unclear why this restriction is relevant. For example, for most couples who both implement testamentary trusts it will be the case that they will die at different times and there will often be a desire to transfer assets between testamentary trusts. It is clearly the case that the excepted trust income rules should continue to apply in this type of situation. To argue otherwise would again see the proposed amendment extend significantly beyond the stated intent of the announced measure and would impact taxpayers in a range of circumstances where there is no inappropriate tax benefit received by a beneficiary.

10 There is arguably no basis for limiting the range of beneficiaries entitled to access the excepted trust income regime to those contemplated by the testamentary trust as originally drafted. Testamentary trusts can potentially last for well over 100 years from the date they are prepared. The only certainty over this type of time period is that there will be changes to the family unit. The Commissioner already has significant power to manage any inappropriate variations to beneficiary classes (eg via the family trust election regime and trust resettlement rules).

11 By adopting an inclusive test (where income only qualifies for excepted trust income status if it is included within one of the three abovementioned limbs) the legislation creates significant administrative difficulties attempting to “trace” assets and income across multiple financial years. In contrast, an “exclusive” test where the default assumption is that the trust income qualifies as excepted trust income would be significantly more robust. Such an approach could simply be subject to a specific exclusion in relation to income from assets which were inappropriately “injected” into the testamentary trust. 

12 This said, given the tracing requirements mandated by the proposed new rules, the legislation if it is to proceed as crafted, should arguably expressly confirm that property transferred from a deceased to a testamentary trust and then later from the testamentary trust to any other trust, including an inter vivos trust, continues to access the excepted trust income regime.

Treasury has provided the following details for those wanting to make submissions. 

Any aspect of this post can be used (with or without acknowledgement) if you would like to make a submission:

Email

mailto:[email protected]

Post

Address written submissions to:

Manager

Small Business Entities and Industry Concessions Unit Treasury Langton Cres Parkes ACT 2600

As usual, please contact me if you would like access to any of the content mentioned in this post.

** for the trainspotters, the title today is riffed from Peter Gabriel's tune 'Sledgehammer'.

View here:

https://www.youtube.com/watch?v=OJWJE0x7T4Q