The new excepted trust income provisions – clarity in the law

Generally, the Income Tax Assessment Act 1936 (Cth)[1] (ITAA36) provides specifically for beneficiaries who are minors to be taxed at higher rates than those of adult taxpayers – effectively, this means that minors will often pay tax on any trust distributions they receive at the highest marginal tax rate, plus Medicare Levy on any amount above $416.   These higher taxation rates on minors imposed by Division 6AA of ITAA36 are targeted at avoiding any tax advantages arising from income splitting arrangements.  As a result, the higher rates apply unless the minor beneficiary is an ‘excepted person’ or the income is ‘excepted income’.

There are a number of different categories of ‘excepted income’.  However there are two categories which apply to income generated on assets sourced from a deceased estate: s102AG(2)(a), and s102AG(2)(d)(i).  It has long since been accepted that assets devolving on an inter vivos trust fall within the provisions of 102AG(2)(d)(i), whereas the provisions of s102AG(2)(a) apply specifically to testamentary trusts established under the provisions of a will.

Section 102AG(2)(a) – testamentary trust excepted income

Prior to the recent changes, the relevant section was as follows:

“Section 102AG

… (2) Subject to this section, an amount included in the assessable income of a trust estate is excepted trust income in relation to a beneficiary of the trust estate to the extent to which the amount:

(i) is assessable income of a trust estate that resulted from:

(a) a will, codicil or an order of a court that varied or modified the provisions of a will or codicil; or

(b) an intestacy or an order of a court that varied or modified the application, in relation to the estate of a deceased person, of the provisions of the law relating to the distribution of the estates of persons who die intestate.”

However, new sub-section 2AA has now been included, which states:

“(2AA) For the purposes of paragraph (2)(a), assessable income of a trust 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 represents accumulations of income or capital from property that satisfies the requirement in subparagraph (i);

(iii) the property 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).”

The legislation implementing the changes[2] specifies in Schedule 1 that the amendments apply in relation to assets acquired by or transferred to the trustee of a trust estate on or after 1 July 2019.

The purpose of this change is stated in the Explanatory Memorandum to the bill implementing these changes[3], that:

“The existing law does not specify that the assessable income of the testamentary trust be derived from assets of the deceased estate (or assets representing assets of the deceased estate). As a result, assets unrelated to the deceased estate that are injected into a testamentary trust may, subject to anti-avoidance rules, generate excepted trust income that is not subject to the higher tax rates on minors. This is an unintended consequence, which allows some taxpayers to inappropriately obtain the benefit of concessional tax treatment.”

The effect of the changes

The ATO has yet to publish a formal and binding position in relation to these changes – the position to date is that published by way of explanation and examples on their website, which is not authoritative and cannot be relied upon, but provides a guide as to how the ATO will view particular circumstances.

It is useful to consider the examples contained within the Explanatory Memorandum (replicated on the ATO website) to understand how this new legislation may create change:

(a) Example 1.1 contemplates a testamentary trust which is established pursuant to a will and contains $100,000. A family trust then injects $1,000,000 into the testamentary trust and the full balance of those funds is invested in listed shares. 

The shares pay dividends in the income year of $110,000. The minor is presently entitled to 50% of those dividends. Under the new legislation, only $5,000 of the minor’s share of the net income is excepted trust income (being the proportion of the dividends attributable to the assets acquired with the initial $100,000 settled upon the trust).

(b) Example 1.2 sees the trustee apply that minor’s share of income and invest it again in listed shares, deriving further income of $5,500. Only $500 of that income is excepted trust income, being derived from the investment of income that was previously excepted trust income.

These examples on their face seem logical. It can be reasonably inferred from the examples that there is no requirement that the property retains the same form – i.e. the cash from the estate was converted to shares and the dividends received from those shares was still excepted trust income.  The ATO’s website also confirms this position:

“Property of a deceased estate includes real property and money from the deceased estate. It can include, accumulations of income or capital from property of that deceased estate, and conversions of such property from one asset type to another. For example, if a trustee of a testamentary trust sells a rental property transferred to the trust from a deceased estate and invests those proceeds in shares, the income from those shares is income from property of the deceased estate.”

 However, the ATO website goes another step further to provide the following example:

(a) A testamentary trust is established with an initial amount of $500,000 from the deceased estate. A family trust contributes a further $500,000. The testamentary trust then borrows a further $1 million and purchases a rental property for $1.9m, with the balance of $100,000 used as working capital for the property.

(b) $50,000 is received in net rental income from the property. The minor beneficiary is presently entitled to 50% of the income, being $25,000. Of the $25,000, the excepted trust income is only $6,250 – being the extent to which the income derived was sourced from the initial $500,000 transferred to the deceased estate.[4]

The effect of that example seems to be that if the trust received $500,000 from the deceased estate and used that $500,000 to borrow further funds to acquire a property, then only part of the income from that property would be excepted trust income. The excepted trust income would only be the income that was generated from the original contribution.  As such, it appears that:

(a) if the trustee reinvests trust profits which are excepted income, then the income from those investments will be excepted income; but

(b) if the trustee borrows from assets (which otherwise would generate excepted income) to acquire assets, then those assets will not generate excepted income (but the loan will be repayable from trust assets which may or may not represent reinvested excepted trust income).

This distinction (which appears on the ATO’s website, but not the explanatory memorandum) is illogical.  It will be interesting to see if the ATO revises its opinion, or are challenged by taxpayers.

The new provisions do not take away from the use of testamentary trusts as an advantageous vehicle to be used in estate planning.  However, those who choose to retain and use testamentary trusts as investment vehicles will need to carefully consider how borrowing, contribution and investment may effect the tax treatment of minors within the trust.

For further information on any of the issues raised in the alert, please contact a member of our tax team below. 

[1] See specifically Division 6AA ITAA36.

[2] Treasury Laws Amendment (2019 Measures No. 3) Act 2020 (Cth).

[3] Treasury Laws Amendment (Measures for Consultation) Bill 2019: Testamentary Trusts, found at https://treasury.gov.au/sites/default/files/2019-09/t398533-exposure_draft_em_testamentary_trusts_final.pdf.

[4] The example can be found here: https://www.ato.gov.au/individuals/investing/in-detail/children-and-under-18s/your-income-if-you-are-under-18-years-old/?page=3.