Borrowing strategy banned from testamentary trust concessions

Brian Hor

Brian Hor

Recently the government passed new laws which limit the treatment of income from a testamentary trust paid to minor beneficiaries of the trust as “excepted trust income” (which would be taxed at adult tax rates, including the all-important tax free threshold of currently $18,200 per year) only to property transferred to the testamentary trust from the deceased’s estate or from property that represents an accumulation of income from property from the deceased’s estate. These new provisions apply to property acquired by or transferred to the trustee of a testamentary trust estate on or after 1 July 2019.

Much has been said by various legal commentators about the possible impact of the new laws where a superannuation death benefit is paid to a deceased estate. However, a recent publication by the Australian Taxation Office has revealed a potentially much greater impact of the new laws on the investment strategies of a testamentary trust.

The Taxation Office have now publicised their own interpretation of the new laws in QC 16509, which as last modified on 26 Jun 2020 provides the following example where a discretionary testamentary trust borrows money:

Example: Rental property acquired with borrowed money, trust distribution and money from deceased estate

Johnston Trust is a testamentary trust established under a will into which $500,000 is transferred from the deceased estate on 22 August 2019. A trustee of a family trust then makes a capital distribution of $500,000 to Johnston Trust. The trustee of Johnston Trust borrows $1 million from a bank and purchases a rental property for $1.9 million. The remaining $100,000 is used as working capital for the rental property.

In the 2019–20 income year, the trustee of Johnston Trust receives $50,000 of net rental income. The net income of the trust for that year is $50,000. Michael, who is under 18 years old, is made presently entitled to 50% of the $50,000 net income, being $25,000.

Michael’s excepted income is $6,250. This amount is the extent to which the $25,000 of income resulted from the $500,000 transferred from the deceased estate (worked out as $500,000 ÷ $2 million × $25,000). The remaining $18,750 of income is attributable to assets unrelated to the deceased estate and is not excepted income.”

Notice how the formula used by the Tax Office specifically limits the excepted income to income generated from the original $500,000 transferred from the deceased estate, and excludes the income generated not just from the family trust capital distribution of $500,000 to the Johnston Trust but ALSO from the borrowing of $1 million from the bank.

This represents a HUGE departure from the long-accepted treatment of income derived by a discretionary testamentary trust from assets acquired using borrowed monies.

Ever since the landmark case of The Trustee for the Estate of the Late A W Furse No 5 Will Trust v FC of T 91 ATC 4007 – way back in 1991, nearly 30 years ago – it was accepted that a discretionary testamentary trust could borrow money to acquire an asset, and the income generated by that asset would be treated as excepted trust income if paid to minor beneficiaries of the trust.

To refresh the memories of those of us who were practising tax law back then (and to educate those of us who were not even born back then), the salient facts of the case were as follows:

  • The trust was established under a Will;
  • Using assets of the deceased estate and further borrowed funds, the trustee acquired units in a unit trust, the trustee of which performed services for a law firm;
  • Income from those units was included in the net income of the testamentary trust in 1982 and 1983. The trustee distributed some of that income to three minor beneficiaries of the trust. The Tax Office assessed the trustee in respect of that income under Division 6AA of the Income Tax Assessment Act 1936 (“ITAA36”) at the rate of 46%;
  • The trustee lodged objections which were disallowed by the Tax Office and which decision was affirmed by the Administrative Appeals Tribunal;
  • On appeal to the Federal Court, it was held that for section 102AG(2)(a)(i) of ITAA36 to operate, it is not necessary that the assessable income of the trust estate be sourced from the property of the deceased. The trustee borrowed funds and used the borrowed funds to invest in such a way to derive assessable income from that investment. In the words of Justice Hill, “the consequence of such an investment was that assessable income was derived by the trust estate so that that income was “assessable income of the trust estate” and clearly enough the trust estate was one that resulted from the will of the late Mr Furse”. Therefore, the trustee’s objections were allowed.

This long-standing principle has now been overturned (according to the interpretation of the Tax Office at least), so that now any income arising from assets acquired on or after 1 July 2019 using monies borrowed externally by a testamentary trust will no longer be treated as excepted trust income if paid to minor beneficiaries of the trust, and therefore will be taxed at the “penal rates” under Division 6AA which reduces a prescribed person’s tax-free threshold from $18,200 to just $416 and then taxes any additional trust income between $417 to $1,307 at 66% and thereafter at 45%.

What does this mean for Estate Planning and Investing with Testamentary Trusts?
Until the interpretation of the Taxation Office in relation to the new provisions is tested in the Courts, estate planning advisers and their clients need to take into account the implications of the new laws in relation to borrowings made by discretionary testamentary trusts.

For instance, the trustees of any testamentary trusts that were considering borrowing funds to acquire new investments (particularly in the current climate of historically low interest rates and a depressed residential real estate market which is likely to suffer even greater falls due to factors such as the impact of COVID-19 on immigration levels and the forthcoming reductions in government assistance to mortgage holders) will need to take into account the possibility that any income generated from such investments may not attract the testamentary trust tax concessions in relation to excepted trust income when distributed to minor beneficiaries of the trust – which may represent a significant reduction in the after tax return from such investments.

Also for estate planning advisers thinking about incorporating discretionary testamentary trusts in the Wills of their clients, it may be important to consider having “opt out” provisions built into the Will, so that in the event that at the time of death the share of the estate of the testator which is to be allocated to a testamentary trust under the Will is insufficient to make the trust financially viable, having regard to the ability of the trust to generate income without borrowings (or with borrowings where the proportion of the resulting income which relates to the borrowings will not be treated as excepted trust income when distributed to minor beneficiaries) vis a vis the ongoing accounting and other costs of maintaining the trust structure, the client’s beneficiaries can effectively bypass the trust and receive their inheritance as a direct gift from the estate.

For expert legal advice and assistance with all types of wills and with issues such as those considered in this article, please contact Townsends Business & Corporate Lawyers.

By Brian Hor, Special Counsel, Superannuation & Estate Planning

You must be logged in to post or view comments.