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Advantages and Disadvantages in Estate Planning and Succession

1. A testamentary trust is simply a trust created by a valid last will and testament (see Ford & Lee 1996 3rd edition Lawbookco para. [1 110] for a discussion of the terminology). The trust commences when the executor finishes administering the estate.
At that point the executor ceases to be an executor and becomes a trustee. Alternatively the will may appoint someone other than the executor to act as trustee.

2. A testamentary trust may be either a fixed or a discretionary trust. This article will be explaining the main reasons for establishing a testamentary trust, and will discuss some of the issues that are likely to arise in drafting the terms of such a trust.

WHY ESTABLISH A TESTAMENTARY TRUST?

3. There are three major reasons for establishing a testamentary trust:

• to exercise control over the future use or disposition of estate assets (for example, by creating life and contingent interests on trust);

• to protect assets from creditors; and

• tax reasons.

(a) Control over future disposition of assets

4. The first reason for establishing a testamentary trust is self-explanatory, which is not to suggest that the drafting is straightforward. In large estates it may call for the exercise of considerable drafting ingenuity to meet the wishes of the client.
A simple and everyday example of a testamentary trust employed to control the future disposition of assets is the life estate.
Creating a life estate in favour of a spouse permits a testator to provide for a loved one while also ensuring that the capital passes to their children or to other relatives.

(b) Asset protection

5. The second reason for establishing a testamentary trust is often the most important, but is relatively simple to explain.
If assets are gifted to an individual who is at risk of claims from creditors or a matrimonial dispute, those assets increase the pool of assets at risk.
If on the other hand the assets are gifted to trustees who have a discretionary power to benefit the intended beneficiary, they should be protected from creditors, even under the most recent amendments to the Bankruptcy Act.
The possibility of providing some access to a pool of assets otherwise outside the reach of creditors may also provide a powerful bargaining lever for the beneficiary.

6. A testamentary trust that confers discretionary powers on the trustees may take much the same form as an inter vivos discretionary trust. One concern that has been expressed about establishing a discretionary testamentary trust is that it might offend the rule against delegation of testamentary power but in Victoria the rule has been abolished: see s 48 of the Wills Act 1997.
In any event, in Gregory v Hudson (1997) 41 NSWLR 573 Young J (at 586) held that the rule against delegation of testamentary power did not apply to a gift under a will to a pre-existing trust or to constitute a trust which is sufficiently constituted according to the rules of certainty in trust law.

7. A testator who does not wish to leave assets on broad discretionary trusts may confer a narrower set of powers on the trustees, but if you are concerned about protecting a beneficiary from creditors it is essential to avoid giving the beneficiary a vested interest in the estate. This means that there must be at least two beneficiaries and the trustee must have power to determine whether or not the beneficiary receives anything at all. For example, a beneficiary who has a life interest in the assets of an estate has a vested interest which a creditor could potentially exploit.

(c) Tax advantages

8. Explanation of the tax advantages of establishing testamentary trusts.

TAX CONCESSIONS ASSOCIATED WITH TESTAMENTARY TRUSTS

9. The taxation rules that apply to testamentary trusts are generally the same as those that apply to inter vivos trusts, but they may attract tax free concessions. The tax concessions are that:

(a) ordinary adult marginal tax rates may apply to infant beneficiaries;
(b) marginal tax rates and the CGT 50% discount may apply to undistributed income; and
(c) distributions of assets from the trustee to a beneficiary may occur free from CGT.

In drafting a testamentary trust the drafter should also ensure that beneficiaries are not disadvantaged in relation to:

(d) taking advantage of the main residence exemption; and
(e) receipt of death benefits from a superannuation fund.

10. Related Tax Issues

(a) Taxation of minors

11. Division 6AA of the Income Tax Assessment Act 1936 ("the ITAA 1936") applies penalty tax rates to the "eligible taxable income" of a "prescribed person".
A "prescribed person" is, subject to some exceptions, a child under the age of 18. The "eligible taxable income" derived by a prescribed person is subject to the following schedule of tax rates:

The low income rebate increases the effective tax free threshold to $1,667 (for 2007-08).

12. Not all income of a minor is deemed by Division 6AA to be eligible taxable income. Income which falls within the definition of "excepted assessable income" is not eligible taxable income and therefore is subject to ordinary marginal rates of tax.
In addition, trust income which is "excepted trust income" falls outside the provisions.

13. "Excepted trust income" is defined in s 102AG(2) of the ITAA 1936 to include, amongst other items, an amount which:

(a) is assessable income of a trust estate that resulted from:

(i) a will, codicil or an order of a court that varied or modified the provisions of a will or codicil; or
(ii) an intestacy or an order of a court that varied or modified the application, in relation to the estate of a deceased person, of the provisions of the law relating to the distribution of the estates of persons who die intestate;

(d) is derived by the trustee of the trust estate from the investment of any property:

(i) that devolved for the benefit of the beneficiary from the estate of a deceased person; ..."

14. Paragraph (a) creates an exception for income from a testamentary trust, including a trust arising from the variation of a will by the court, while sub-paragraph (d)(i) confers special status on property gifted to an existing trust in the will of the testator.

15. The exception for trusts created under a will is not restricted to the assets that originally belonged to the deceased. Therefore, any income that a testamentary trust earns may qualify for the exemption: see The Trustee for the Estate of the late A W Furse No 5 Will, Trust v FCT (1990) 21 ATR 1123 at 1136.

16. For example, a strategy that was popular 20 years ago was to establish a unit trust at the same time as the child maintenance trust. The settlor transferred the units in the unit trust to the child maintenance trust. Neither the child maintenance trust nor the unit trust had any assets of substantial value but the unit trust was the beneficiary of a discretionary trust that did produce substantial income. The trustee of the discretionary trust distributed sufficient income each financial year to the unit trust to satisfy the maintenance obligation. The unit trust in turn distributed the income to the child maintenance trust. (The structure is described in TR 98/4 at paragraph 22.)

17. But arrangements to inflate the income of a testamentary trust may fall foul of two anti-avoidance provisions.
The first anti-avoidance rule, which is in s 102AG(3), proved to be effective to frustrate this strategy: sec Case 44/95 95 ATC 387 and The Trustee for the Estate of the late A W Furse No 5 Will Trust v FCT (1990) 21 ATR 1123. The first rule limits excepted trust income to the income that would have been earned if all parties to the derivation of the income had been dealing with each other at arm's length. Subsection 102AG(3) provides that:

Subject to subsection (4), if any 2 or more parties to:

(a) the derivation of the excepted trust income mentioned in subsection (2); or
(b) any act or transaction directly or indirectly connected with the derivation of that excepted trust income;

were not dealing with each other at arm's length in relation to the derivation, or in relation to the act or transaction, the excepted trust income is only so much (if any) of that income as would have been derived if they had been dealing with each other at arm's length in relation to the derivation, or in relation to the act or transaction.

18. The second rule applies if the income arises from an agreement entered into to secure that income is excepted trust income. Subsection 102AG{4) is much broader than subsection (3) and could apply to a wide range of circumstances. It provides that:

Sub-section (2) does not apply in relation to assessable income derived by a trustee directly or indirectly under or as a result of an agreement that was entered into or carried out by any person (whether before or after the commencement of this sub-section) for the purpose, or for purposes that included the purpose, of securing that that assessable income would be excepted trust income.

19. "Agreement" is defined to mean any agreement, understanding or scheme, whether formal or informal, whether express or implied and whether or not enforceable or intended to be enforceable, by legal proceedings: s 102AA(1) of the ITAA 1936.

20. Section 102AG(5) provides that in determining whether s 102AG(4) applies, no regard shall be had to a purpose that is a merely incidental purpose. An agreement made as part of the drawing and execution of a will would most likely be for the purpose of providing for the distribution of the testator's assets after death, not for the purpose of securing the tax concession within Division 6AA.

(d) Taxation of undistributed income

21. Undistributed income of a trust is, in general, taxed under s 99A of the ITAA 1936 at the top marginal rate plus the Medicare levy.
Another section, s 99, may apply in preference to s 99A in limited circumstances. Section 99A applies unless the trust estate resulted from:

(i) a will, a codicil or an order of a court that varied or modified the provisions of a will or a codicil; or
(ii) an intestacy or an order of a court that varied or modified the application, in relation to the estate of a deceased person, of the provisions of the law relating to the distribution of the estates of persons who die intestate;

If the Commissioner is of the opinion that it would be unreasonable that this section should apply in relation to the trust estate in relation to that year of income." (see section 99A(2)(a))

22. The marginal rates applicable depend on whether the relevant trust estate is a deceased estate or a testamentary trust and whether the deceased person died less than 3 years before the end of the year of income (Income Tax Rates Act 1986, Sch 10, Part I).
If the trust estate is a deceased estate and the deceased died less than 3 years before the end of the year of income, ordinary marginal rates apply. If the trust estate is a deceased estate and the deceased died more than 3 years before the end of the year of income, or if the trust estate is a testamentary trust, ordinary marginal tax rates apply, except that the tax-free threshold is not available.

23. When deciding whether to exercise the discretion to exempt a deceased estate or testamentary trust from the operation of s. 99A, the Commissioner must take into account a list of specified criteria which are intended to determine the extent to which the trust has been or could be used primarily as a vehicle for tax minimisation (see s 99A(3) and (3A)). The Commissioner would normally exercise the discretion to apply s 99 to a deceased estate provided no tax avoidance is involved and the administration of the estate is not unduly delayed.

24. In ATO ID 2002/673 the Commissioner applied marginal rates under s 99 to tax the income from a testamentary trust rather than the top marginal rate under s 99A. The main consideration in exercising the discretion favourably, according to the decision, was that no attempt had been made to increase the assets of the trust by, for example, granting of special rights or privileges to the trust or by transferring property to it, or the making of loans to it. Unfortunately, ATO ID 2002/673 has been withdrawn, on the basis that it "does not adequately reflect the ATO view".
Given the terms of s 99A, a trustee would have a strong case to argue that the s 99 rates should apply provided the assets of the testamentary trust have not been added to after death.

25. If a trustee is taxable under s 99A on a capital gain the 50% CGT discount does not apply. But the CGT discount may apply if the trustee is taxed under s 99. Therefore, the question whether s 99 or s 99A applies to the trustee is especially significant if the trustee has undistributed income that includes a taxable capital gain.

(e) Capital gains tax exemption

26. Under s 128-15(3) no CGT applies if an asset passes from a legal personal representative to a beneficiary in accordance with the terms of the will. In PS LA 2003/12 the Commissioner indicated that s 128-15(3) also applies if an asset passes from the trustee of a testamentary trust to a beneficiary, provided the asset concerned is an asset that originally belonged to the deceased. The Commissioner has confirmed this interpretation in a public ruling - see TR 2006/14. Therefore, if an asset is gifted to a testamentary trust, no CGT will be triggered until the trustee or the beneficiary disposes of it to a third party.

27. The rules as they are currently interpreted therefore may permit a lengthy deferral of CGT. But it is important to note that the exemption only applies to assets that originally belonged to the deceased. If the trustee acquires an asset other than from the deceased's estate that asset would be subject to the ordinary CGT rules.

(f) Taking advantage of the main residence exemption

28. One of the two potential pitfalls that the drafter needs to bear in mind is ensuring that the estate can benefit from the main residence exemption. If a beneficiary, other than the deceased's spouse or the devisee of the dwelling, is likely to occupy the deceased's principal residence, the testator should consider giving that individual a right to occupy the dwelling under the will, or under the terms of any testamentary trust established under the will. If the beneficiary subsequently occupies the home, the existence of the right to occupy may allow the executor/trustee to satisfy one of the requirements for the main residence exemption under the table in s 118-195(1) of the Income Tax Assessment Act 1997 ("the ITAA 1997").

29. Section 118-195(1) provides an exemption from CGT if a beneficiary in a deceased estate or a personal representative of an estate sells a home and at least one of the items in columns 1 and 2 are satisfied. The table is as follows:

30. If a testator leaves their house to be held on trust by the trustee of a testamentary trust there are a number of ATO Interpretative Decisions that indicate that unless the will grants an explicit right to a beneficiary to occupy the dwelling, the condition in Item 2(b) of the second column of the table in s 118-195(1) is not satisfied. For example, ATO ID 2003/109 indicates that if a beneficiary of an estate who docs not have the right to occupy the dwelling under the will in fact occupies it, this will not satisfy the requirement for exemption.

31. Another ATO ID, ATO ID 2004/882 considers the position of a dwelling that the deceased had acquired before 20 September 1985. The dwelling was the deceased's main residence until the time of her death in March 2000. Under the deceased's will the dwelling was to be held on trust for her children. Under their will, the deceased granted one of her children the right to occupy the dwelling for a period of up to 18 months. The will also specified that the trustees were unable to dispose of the dwelling during this period. The child who was granted a right to occupy the dwelling resided in it from the time of the deceased's death until the dwelling was sold in June 2003. From the end of the 18 month period until the time when the trustee ceased to own the dwelling, the deceased's child resided in it under an agreement with the trustees and other beneficiaries.

32. The trustees made a capital gain on the disposal of the dwelling. According to the ATO, because the deceased's will conferred on her child a right to occupy the dwelling only for a limited period the trustees were unable to claim a full main residence exemption under subsection 118-195(1) of the ITAA 1997. But they were entitled to a partial exemption under section 118-200 of the ITAA 1997, based on the number of days during which the conditions for the exemption were satisfied.

33. If the testator wishes to leave their home to their trustees to hold on a discretionary trust it is worth giving some thought to the possibility that one or more specific beneficiaries may wish to occupy the house. If this is a possibility it may be appropriate to draft a provision in the will that gives the beneficiary likely to occupy the dwelling an explicit right of occupancy.

(g) Death benefits

34. A second potential pitfall relates to death benefits. Death benefits are, broadly speaking, payments received from a superannuation fund or from a former employer as a result of the death of a member of the superannuation fund or of a former employee. If a death benefit is received directly by a "death benefit dependant" it is tax-free.

35. There are significant changes to how death benefits are taxed that took effect from 1 July 2007. The new rules have abolished the concept of "reasonable benefits limits" and draw a distinction between "superannuation death benefits" and "death benefit termination payments".

36. Superannuation death benefits are very common and often involve large sums. As the name suggests, a "superannuation death benefit" is, broadly speaking, a payment from a superannuation fund after the death of another person paid because the other person was a member of the fund: see s 307-5(4) of the ITAA 1997. A superannuation death benefit may be received by a person acting as a personal representative.

37. If death benefits are received by a personal representative they are treated as income to which no beneficiary is presently entitled: see ss 82-75(2)(b) and (3)(b) and 302-10(2)(b) and (3)(b) of the ITAA 1997. The executor is therefore responsible for any tax liabilities associated with the payments, usually under s 99 of the ITAA 1936. The personal representative is taxed in accordance with how the person or persons intended to benefit from the estate would be taxed if they received the payment directly: ITAA 1997, s 302-10.

38. To the extent that a "death benefit dependant" of the deceased has benefited, or may be expected to benefit, from a superannuation death benefit the benefit is taxed as though it had been paid to a dependant. This means that it is tax free, no matter how large the payment: see s 302-60 of the ITAA 1997. The old rules, in contrast, limited the tax free amount to the deceased's reasonable benefits limit. The reasonable benefits limits were abolished so this restriction no longer applies.

39. To the extent that one or more beneficiaries who are not "death benefits dependants" of the deceased have benefited, or may be expected to benefit, the benefit is taxable. The legislation assumes that a payment will benefit either a dependant or a non-dependant. However, not all the assets of an estate necessarily pass to the beneficiaries. It is not clear, for example, how one treats a death benefit that the executor applies in paying debts and testamentary expenses. The test for the exemption under the old rules was formulated differently. The part of a death benefit that was exempt from tax was such amount as the Commissioner considered appropriate having regard to the extent to which dependants of the deceased might reasonably be expected to benefit from the estate. The remainder of the payment was taxable.

40. The critical element of both the current and the new rules is the definition of "death benefit dependant" (''dependant" under the old rules). Under s 302-195 of the ITAA 1997, a "death benefit dependant" is:

(1) any spouse (defined under s 6(1) of the TTAA 1936 to include a de facto spouse);
(2) any child of the testator under 18;
(3) any person with whom the deceased was in an "interdependency relationship" immediately before death; and
(4) any other person who was a dependant of the deceased immediately before death.

"Interdependency relationship" essentially refers to relationships in which one person is dependent upon another for domestic and financial support: see ITAA 1997, s 302-200.

41. Why does any of this matter? If a superannuation fund trustee pays the death benefit to the estate, and the money forms part of the trust fund of a testamentary trust that has a broad range of beneficiaries, it may be difficult to persuade the Commissioner of Taxation that dependants would be reasonably expected to benefit from the estate. For this reason drafters often provide for the executors to pay death benefits directly to dependants or alternatively for any death benefit to be held on a separate trust for the deceased's dependants. The will therefore needs to include a definition of "dependants" that is consistent with the definition of "death benefits dependants" in the ITAA 1997, and make specific provision for any death benefits to be held for the benefit of those dependants.

42. This makes the drafting of a testamentary trust much more complicated, because testators would usually wish to give fixed shares of their estates to their beneficiaries. The drafter therefore needs to give the personal representative power to adjust the shares of those beneficiaries who are not dependants so that the shares received by beneficiaries who do not receive a part of the death benefit are increased to equalise them with the shares received by the beneficiaries who are death benefits dependants.

43. In many cases it would be more straightforward for the testator to give directions to the superannuation fund trustee to pay the death benefit directly to his or her dependants.

M T FLYNN Owen Dixon Chambers West 2 September 2008
THE AUSTRALIAN ITALIAN LAWYERS ASSOCIATION TESTAMENTARY TRUSTS

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