Testamentary trusts versus SMSFs

The premise behind the changes is informed by the Superannuation (Objective) Bill 2016 introduced into the federal Parliament on 9 November 2016 which, if enacted, will enshrine the objective that superannuation tax concessions are intended to encourage people to save for their retirement and, despite what a majority of superannuants probably believe, not to provide people with the opportunity for tax minimisation or estate planning.

The changes being introduced by the government include:

• A $1.6 million superannuation transfer balance cap;
• Reducing the threshold for taxation of concessional superannuation contributions to $250,000;
• Lowering the annual non–concessional contributions cap to $100,000; and
• Abolishing the anti–detriment rule.

Some commentators are now questioning the long-term effectiveness of superannuation trusts as against traditional testamentary trusts, particularly testamentary discretionary trusts for wealthy individuals.

The truth is that both have their place and no doubt high-net-worth individuals will take advantage of superannuation trusts and testamentary discretionary trusts where applicable.

While the tax advantages of SMSFs are no doubt well-known to readers, what is a testamentary trust and what are they used for? Testamentary trusts offer opportunities for both asset protection and tax advantages and for some, the asset protection they provide is more attractive than their tax effectiveness.

Essentially, a testamentary trust:

(a)          Comes into existence not when the testator signs the will but rather, when the testator dies;

(b)          Separates the ownership of trust assets from the beneficiaries and vests the legal title of those assets in the trustee;

(c)           May be – 

(i)            A ‘bare trust’ or a ‘fixed trust’; or

(ii)           A ‘discretionary trust’; or

(iii)          Mandatory or optional;

(d)          As set out below, offers potentially significant tax advantages;

(e)          Gives asset protection to a beneficiary, either from the beneficiary themselves or a third party; and

(f)           In every state except South Australia (which has no limit), the duration of the trust must not exceed a period of 80 years from the date upon which the trust commenced.

Wills establishing the testamentary trusts will nominate:

(a)          A ‘trustee’ who is responsible for administering the trust and may be the executor and/or some other natural person/s or a corporation;

(b)          A ‘primary beneficiary’ if a fixed trust or a ‘class of beneficiaries” if a discretionary trust;

(c)          An ‘appointer’ who has the power to remove and appoint trustees; and

(d)          Sometimes, but not always, a ‘protector’ is nominated, being a person with “consent powers” to which some powers of the trustee are subject, effectively a veto power over the trustee.

If the will provides for the trustee to hold certain estate assets on trust for a beneficiary until a particular time (e.g. until the beneficiary attains 21 years of age) but has no other terms or conditions, it will be a bare testamentary trust.

If the will creating the testamentary trust contains other specific terms, then it will be either a fixed testamentary trust or a discretionary testamentary trust. The distinction is important to be able to identify the interest that a beneficiary holds in the assets of the trust.

The beneficiaries of a testamentary fixed trust will have an equitable proprietary interest in the assets of the trust which is indefeasible against the world at large except for a bona fide purchaser for value without notice.

On the other hand, the beneficiaries of a testamentary discretionary trust do not have an equitable proprietary interest in the assets of the trust but rather, the beneficiaries have only a personal right (a chose in action) to the due administration of the trust – being a right to call upon the trustee to deal appropriately with the income and capital of the trust.

In recent times, the effectiveness of trusts to provide asset protection have been reduced in bankruptcy and family law situations, particularly the latter where in some circumstances courts have held the trust to be no more than the ‘alter ego’ of the spouse, thereby declaring trust assets to be marital property available for division between the parties.

A ‘mandatory testamentary trust’ is more likely to be considered for a vulnerable beneficiary. For example:

(a)          The beneficiary is an infant or has not otherwise reached the age nominated in the will;

(b)          The beneficiary is affected by drug or gambling addiction;

(c)           The beneficiary is severely disabled and unable to manage their own affairs; or

(d)          The beneficiary is vulnerable to a creditor or a likely family law dispute over property.

An ‘optional testamentary trust’ is more likely where the beneficiary is being offered the opportunity to take advantage of the benefits a testamentary trust has to offer but the testator does not want to impose the testamentary trust upon an unwilling beneficiary. If the option for the testamentary trust is exercised, it will be exercised by the executor rather than the beneficiary (but obviously with input from the beneficiary) to ensure the trust structure is not impeached.

Tax advantages of discretionary testamentary trusts

A trust is not a separate legal entity like an individual or a corporation. The taxation of trusts is governed mostly by Division 6 Part III Income Tax Assessment Act, 1936 (ITAA 1936) and Chapters 3-1 and 3-3 Income Tax Assessment Act 1997 (ITAA 1997).

In summary:

(i)            The ‘net income’ of a trust is calculated as if the trust were an individual resident taxpayer;

(ii)           To the extent that a beneficiary is ‘presently entitled’ to part of the net income of the trust, the beneficiary will be assessed as having received that net income and will be liable to tax at their marginal rate of tax;

(iii)          To the extent that there is net income of the trust to which there are no beneficiaries presently entitled (e.g. because the trustee did not make a distribution of that part in any given financial year), the income will be taxed in the hands of the trustee at the highest personal tax rate (45 per cent).

(iv)         Whereas minors receiving a distribution of net income from an inter vivos trust will pay the highest tax rate of 45 per cent for any income exceeding $416, minors receiving a distribution of net income from a testamentary trust are specifically exempted from those penal rates of tax and enjoy the same tax free threshold as adult resident taxpayers, namely $18,200.

(v)          For capital gains tax purposes, the transfer of an asset from the deceased to a beneficiary is not a CGT event that will trigger a CGT liability which will be deferred until the beneficiary subsequently disposes of the asset. However:

(a)          For pre-CGT assets (acquired before 20 September 1985), the ‘cost base’ for future CGT liability will be the date of death of the deceased;

(b)          For post CGT assets (acquired on or after 20 September, 1985) the beneficiary stands in the place of the deceased and will have the same cost base as the deceased had at the time of death;

(c)           The deceased’s principal residence will be exempt from CGT if sold by the executor within two years from the date of death, but can be extended if the property continues to be occupied by a beneficiary of the trust who is given a right of occupation under the will.

It will be seen from the above that a testamentary discretionary trust permits considerable flexibility to minimise tax by reason of:

(i)            The ability to make distributions to minors taking advantage of the full adult taxpayer tax-free threshold;

(ii)           Being able to determine which persons among a class of beneficiaries should receive a distribution and the quantum of that distribution among beneficiaries with the most concessional marginal tax rates or ‘streamed’ to the beneficiaries;

(iii)          Where a CGT asset is property in a discretionary testamentary trust and is sold (as opposed to being appointed to a beneficiary of the trust), the capital gain generated can be distributed among beneficiaries with the most concessional marginal tax rates or streamed to the beneficiaries. 

Family provision claims

No comparison of superannuation trusts and testamentary trusts would be complete without the mention of family provision claims. 

Family provision legislation is in force in all states and territories in Australia and allows ‘eligible persons’ who claim they have been left with inadequate provision for their ‘proper maintenance, education or advancement’ in life to apply to the court for provision out of the deceased’s estate.

An eligible person is:

(i)            A spouse (married, defacto, domestic partner);

(ii)           A child;

(iii)          A grandchild;

(iv)          A person ordinarily resident in the household and dependent upon the deceased.

Assets in a testamentary trust are vulnerable to being attacked in a family provision claim.

Unless paid to the ‘personal legal representative’ of a deceased by the trustee of a superannuation trust, superannuation benefits do not form part of a deceased person’s estate.

Leaving aside family law disputes where superannuation is regarded as ‘matrimonial property’, a superannuation member may seek to avoid family provision claims by ensuring a binding death benefit nomination is lodged with the superannuation trustee of retail superannuation funds or a provision to that effect is included in an SMSF superannuation deed.

In all states except for NSW, this will ensure the superannuation benefits are outside the estate and cannot be clawed back into the estate for the purpose of a family provision claim.

In NSW, however, the court has the power to declare assets held by third parties (including superannuation benefits) to be ‘notional property’ available for the court to attach for the purpose of making a family provision order.

As mentioned on the outset, both superannuation trusts and testamentary discretionary trusts will have their place in the estate planning arrangements of many people.

Geoff Brazel, solicitor, Brazel Moore Lawyers