Super death benefits and testamentary trusts: Clarity and concerns

Recent articles have explored the 2018 federal budget announcement 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”.

In introducing the changes, the explanatory memorandum confirmed that the new measures were believed to have a “small unquantifiable gain to revenue over the forward estimates period”.

This admission (leaving aside the obvious question of why the changes were in fact needed in the first place) may indirectly provide comfort for willmakers wanting superannuation death benefits to pass to a testamentary trust.

Superannuation death benefit payments 

In particular, there have been concerns that the new rules do not address how assets — such as a superannuation death benefit — that are acquired by a testamentary trust as a consequence of the willmaker’s death, but are not directly from the willmaker personally, will be treated. 

Aside from the asset protection benefits offered by testamentary trusts, the issues from a tax planning perspective in relation to superannuation death benefit payments are critical.

This is because if superannuation death benefits are not caught by the new rules, future income distributions sourced from the capital contribution to the testamentary trust to an infant beneficiary will be treated as excepted trust income.

This means that instead of the normal penalty rates of tax being imposed for anything above around $416 of distributions to minors each year, children are instead treated as adults for tax purposes.

In other words, children can be entitled to all the normal individual scaled rates of taxation, meaning that for each child, each year, they can potentially receive over $20,000 completely tax-free of income sourced from the original superannuation death benefit.

Arguably, the rules in relation to superannuation death benefit payments are not as clear as they could be. This said, the preferred interpretation appears to be that so long as a death benefit is paid to the legal personal representative of an estate, before then passing to a testamentary trust, this should be sufficient to ensure that any income later derived will be excepted trust income.

In contrast, if a death benefit passes directly from a superannuation fund to a legal personal representative in their capacity as the trustee of a testamentary trust, then there is a material risk that the death benefit will be deemed to be “injected” into the testamentary trust in a manner that is caught by the new rules. This is because the payment would not strictly pass via the estate of the deceased willmaker. 

Practically, most specialist holistic estate planning advisers tend to recommend against death benefit payments being made directly to any form of trust. This is due to the potential difficulties with meeting the legislative requirement for a superannuation death benefit payment to only be made to dependants or the legal personal representative.

Accessing excepted trust income 

The conservative view is that the reference to legal personal representative is of the estate, not a testamentary trust established under the estate. Adopting the conservative interpretation should therefore, counterintuitively, help ensure superannuation death benefits can be the source of future concessional excepted trust income distributions.

Furthermore, superannuation death benefits have been a long-standing and arguably significant source of excepted trust income distributions for those utilising testamentary trusts as part of a holistic estate plan.  

Removing the ability for superannuation death benefits to continue to be a source of excepted trust income would fundamentally contradict the admission in the explanatory memorandum that the new measures will have a small unquantifiable gain to revenue.

Tracing will be key 

Particularly where there are tax dependants who are potential beneficiaries of a testamentary trust, there has been a long-standing need to ensure a “tracing” of superannuation death benefit proceeds paid to a deceased estate.

The new rules are likely to further heighten the need for methodical tracing in relation to superannuation death benefits.

For example, assuming that the original death benefit can be used to validly create excepted trust income, given the likelihood that the death benefit payment will be converted into other assets, there will be the need to demonstrate that the source of funds for those assets was the death benefit.

In turn, future income will need to be traced to the original death benefit payment in order to be able to be treated as excepted trust income.

Conclusion 

To coin a related estate planning phrase, rumours of the death of testamentary trusts have been somewhat exaggerated.

While the level of ongoing income tax flexibility will undoubtedly be lessened by the new rules, the reality is that there are still significant advantages from an income tax planning perspective despite the changes — not least of which because, with proper tracing and accounting, superannuation death benefits should still be a legitimate source of excepted trust income distributions.

Furthermore, there are a range of other fundamental reasons that most people value testamentary trusts, other than simply accessing the excepted trust income regime — for example, asset protection, limited liability, flexibility in asset management and access to the 50 per cent capital gains tax discount afforded to all forms of trusts.

Matthew Burgess, director, View Legal