Further guidance needed on testamentary trusts and borrowings

Speaking in a recent webinar, DBA Lawyers senior associate William Fettes explained that under division 6AA of the ITAA36, minors can be taxed as adults in respect of excepted trust income.

“This effectively allows minors receiving a distribution from a testamentary trust to be taxed at adult marginal tax rates, including the tax-free amount up to the current $18,200 per annum,” Mr Fettes stated.

“Having access to that mechanism in terms of the income generated within the testamentary trust is quite powerful.”

However, Mr Fettes warned that practitioners need to consider the impact of Treasury Laws Amendment (2019 Measures No. 3) Act 2019 (Cth), which was passed in 2020 and limits access to adult marginal tax rate concessions.

Section 102AG(2AA), he said, limits this concession to income derived on property transferred from the deceased estate to the trust as well accumulations of income or capital in respect of this property and income derived from property that represents previous accumulations of said income/capital.

“In other words, you can have the property or assets that have devolved from the estate to the testamentary trust. You can have income that represents an accumulation on that property. [You can also have] any property that’s reinvested with those accumulations that generates income – all of that will still be accepted trust income,” he clarified.

“[However], if we all foul of 2AA, we’re no longer going to be afforded those concessional rates to distributions of income to minors.”

Based on its published materials, Mr Fettes warned that the ATO has taken a “fairly strict view on this”.

Mr Fettes said the provisions still allow for property to be converted into other assets, so it is not a problem if the testamentary trust receives cash and converts it into another investment. However, practitioners and clients “need to be mindful of injected capital”.

“The provisions are really aimed at denying adult marginal tax rate concessions for income distributed to minors, where there’s not this direct devolution from the estate,” he explained.

The examples given in the explanatory materials for the legislation cover the concept of a discretionary trust making a distribution to a testamentary trust, in effect, to increase the pool of assets in the testamentary trust.

“In that case, the injected capital and the income on that capital will not be relevant for excepted trust income status for when it’s distributed to a minor,” he said.

These provisions, he warned, create some potential issues for borrowing in a testamentary trust, particularly based on the ATO’s view of this legislation.

Mr Fettes said that back in 1990, the Commissioner’s narrow approach to testamentary trust and excepted trust income status was rejected in the decision of The Trustee for the estate of the late A W Furse (No 5) Will Trust v FCT (1990) 21 ATR 1123.

“[In this case] the will left the sum of $1 to the trustee of a trust. The trustee then received a loan of $10 from another company. Part of that money was used to purchase units in a unit trust on behalf of a testamentary trust, and the trust subsequently distributed income derived on the units to three minors,” he explained.

“Justice Hill, rejected the Commissioner’s narrow approach to these facts, and basically said that it was allowed that excepted trust income status would flow to the income on the units, even though there was gearing involved in how those units were acquired by the trustee of the testamentary trust.

“That’s been the law for some time. [However], in a departure from Furse, the ATO’s view now is that borrowing by the trustee of a testamentary trust is not within the scope of allowable accumulations on property devolved from the estate. So, we’re now in a different situation.”

In its materials, the ATO gives an example of a testamentary trust, established under a will called the Johnston Trust. $500,000 is transferred into the Johnston Trust from the deceased estate.

“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 2020-21 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 per cent of the $50,000 net income, being $25,000,” the example stated.

“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.”

Mr Fettes said that looking at the example, the ATO doesn’t just proportionally deny the excepted income concession based on the distribution from the family trust; they deny it in respect of the borrowing as well.

“This is quite an assertive position being taken by the Commissioner, that the trustee of the discretionary trust shouldn’t be borrowing if it wants to preserve the excepted trust income status for distribution to minors,” he warned.

“So it appears to be that it’s not just about injections of capital, it’s about accumulations of property or other accepted trust income.”

Mr Fettes said this raises a question around whether there’s any difficulty under the ATO view where the trustee of the trust invests in a separate entity that’s internally geared.

“Surely that’s just converting one form of property into another, and so you’re just shifting where the gearing is. So the trustee of the testamentary trust doesn’t borrow, but it invests in another entity that is internally geared. That doesn’t appear to be a problem under these provisions, and the ATO doesn’t suggest that that’s any kind of problem,” he said.

“Does that just mean we have to make sure that the gearing has shifted into the interposed entity rather than being in the trust itself? That’s my understanding of the rules.

“However, if the testamentary trust itself borrows, then we are in this territory where the ATO’s example appears to deny the concession of excepted trust income. Although that is not in the EM, this is the ATO’s position, which is a fairly aggressive position on that not representing accumulation on property that’s devolved from the estate or other excepted trust income.”

Mr Fettes said he is hopeful the ATO will provide further clarity on the Commissioner’s position on this.

“Perhaps they’ll walk it back a little, but for the time being, that’s their current guidance published on their website,” he warned.