The use of a testamentary trusts for estate planning has been common practice for many Perth business families. The testamentary trust has fantastic taxation, asset protection and estate planning flexibility.
However from 1 July 2019 the government is intending to strip down the tax benefit that people enjoy in a testamentary trust.
However to understand what taxation benefit that testamentary trusts are losing it is firstly important to understand what the current tax benefit of a testamentary trust – regardless of whether you are in Perth or across regional WA.
Taxation of a child’s income
If a child generates taxable income from working that income as taxed in the same way as everybody else. So a 15 year old who makes, say $9k, working at the local supermarket will enjoy that income completely tax free. In fact that teenager can earn around $21,500 and not incur income tax.
Stopping tax avoidance
However if a child makes income from investments the government treats the taxation treatment very differently. In effect the income is taxed in a similar way to a tax avoidance scheme and it is taxed at the highest tax rate.
So if a baby say made, $100,000, by share trading: that income of the child would be taxed at 47%. And it would be relatively easy to setup a share trading account as the trustee for an infant.
So the concept itself is relatively simple. If the income of the child is “real” income then the child is taxed just like the rest of us. However if the income is effectively manufactured then that income is taxed at penalty tax rates – simply to take away the incentive for tax accountants across Perth and further afield.
An inheritance is different
However if the monies generated by a child is from investment income of a deceased estate the government treats this differently. That income is clearly not “fake” – the child has acquired an asset at a young age and it is unfair for the government to tax that child simply because they are young.
This creates an opportunity for a testamentary trust. Because you practically cannot give a $1m inheritance to (say) a baby.
What is a testamentary trust?
And quite often the inheritance will be for the benefit of several family members. So if a decision is made for the estate to be bequeathed to the family at large, with a bit of discretion each year on who should benefit, then we have a “testamentary trust”.
Essentially a testamentary trust is a trust created on death. The word “testamentary” is derived from the latin word “testāmentārius” which means “belonging to a will”.
So if say, $1m (earning 5%), was bequeathed to a testamentary trust: the trustee can choose to benefit an adult on the highest tax rate that income or it could be split among three children.
If the trustee chose to allocate the income among the three children no income tax would arise. If that same income was allocated to an adult around $23,500 in tax would originate.
The government proposal
The government intends for the tax exemption to only apply to the original asset that was bequeathed to the testamentary trust on death or its subsequent proceeds from disposal.
Sadly there is not (yet) legislation on the proposal. And for an asset like say, a house, the tracing is really quite simple. If the house is sold the tax exemption is lost.
However the practical application of the law is more complex. In effect what looks like an integrity measure might require a tracing of the fund monies from the original starting date to prove the “pure” element of the trust assets.
Further, if the testamentary trust is purchasing fund assets of related parties there could quickly be a mixing of trust assets with “outside assets”. This might ultimately end up with a “superannuation like” standards on the operation of the testamentary trusts.
Essentially if a literal interpretation of the government budget takes place many testamentary trusts, or their intended uses, will become less effective from a taxation perspective.
Watch out for the law
If the government intends to carry through with the law it will be necessary to review estate plans and the current tax profile of assets within the estate plans. The tax strategy of a deceased estate might be to lean towards “stickier” assets that move less often; ensure the estate is not transferring assets around internally or taxation structuring strategy might be to bequeath tax entities to the testamentary trust so that the original asset (say a company) with the testamentary trust is unchanged but the assets inside the tax entity can change.
What is important is that the tax advisors helping business families across Perth will need to be aware of these changes and how it works within the overarching succession strategy of those businesses. This cannot yet be done as the black letter law has not yet been issued: and we have a short window of time to become prepared.
At Westcourt we are fortunate to have worked with many great estate planning lawyers, family business advisors and investment advisors to collaborate on succession and estate plans. However the ongoing and yearly management of an estate plan is critical to ensure that the family business legacy is effectively transferred.