Testamentary trusts have been pulled from the taxation fire they landed in on budget night, but, as Jason Spits writes, may still face some heat as the government reassesses their operation and who can benefit from them.

For those working in the superannuation sector, this year’s budget introduced no new changes, as much of those had taken place as part of the introduction of Division 296. Instead, tax reform was the key theme to emerge, with changes to capital gains tax, negative gearing and the introduction of a minimum 30 per cent impost on discretionary trusts.

Those first two changes were foreshadowed by the government at its Economic Reform Roundtable last year as part of efforts to address intergenerational equity and housing affordability, but the tax on trusts was more of a left-field play and was flagged quickly by those familiar with the use of those vehicles.

WMM Law director Kimberley Martin says the immediate concern with the budget announcement from an estate planning perspective was the impact on vulnerable beneficiaries who receive inheritances through testamentary trusts, which fall within that broad category of discretionary trusts.

But no budget bill survives first contact with public scrutiny or parliament unscathed and this year was no exception with clarifications and modifications being made, including a key statement from Prime Minister Anthony Albanese on 18 June that the proposed tax would not apply to all discretionary testamentary trusts provided they were established for genuine testamentary purposes.

“The difficulty we had, and why the estate profession lobbied for this change, was because we don’t use these structures for tax advantages as a primary purpose. A lot of the time they are to protect children who have lost a parent, or adults living with disability, beneficiaries experiencing addiction, people at risk of bankruptcy or financial exploitation. There are lots of reasons why testamentary trusts are viewed very differently and for decades have been viewed very differently to the discretionary trust or the family trust,” Martin adds.

This exemption is important for estate planning purposes, but the original announcement of a minimum 30 per cent tax on discretionary trusts is indicative of the fact the government has genuine concerns over what goes on inside them and has decided to act, Accurium head of tax education Lee-Ann Hayes points out.

“The fact that discretionary trusts were specifically mentioned on budget night meant the government has got something in mind with them and there was a concern that testamentary trusts are being used more broadly than what the tax concessions really allow for,” Hayes indicates.

“Perhaps the government doesn’t think the rules are effective or it is worried having a testamentary trust would be a mechanism to get around the minimum 30 per cent tax, but it has stepped back from that, given the backlash it got.”

However, Sladen Legal director Phil Broderick points out that logic has never really applied to testamentary trusts, given they are triggered by the death of the person who sets out the terms of the trust in their will, a fact which appears to be recognised by the government with its exemption.

“The thing to take into account is nobody is deliberately setting up a testamentary trust and implementing it for themselves because you have to die first to enact it. It’s not like a discretionary trust where you can choose to set it up. For you to set up a testamentary trust, you have to die. It’s an estate planning tool, it’s not a tax avoidance tool,” Broderick explains.

“Recent history suggests the funnel into these will be narrowed. At the moment your typical testamentary trust is drafted like a normal discretionary trust, which means the beneficiaries could be children, but also all sorts of relatives of the deceased parents, as well as companies, trusts and charities.

“I suspect when we finally see the legislation, they won’t allow those big, wide classes with beneficiaries like that or at least won’t allow flow-through taxation to that big class of beneficiaries, and restrict it just to children and lineal descendants and financial dependants.”

Broderick is referring to the latter conditional clause in the exemption announced in June that “no tax would apply to a testamentary trust established for genuine testamentary purposes”, but according to View Legal director Matthew Burgess, that proviso has not been defined yet and could be applied in either very broad or narrow terms.

“The phrase ‘genuine testamentary purposes’ is concerning because it is not a settled technical test in the way advisers need it to be,” Burgess notes.

“A testamentary trust is, by definition, created by a will or testamentary instrument and takes effect after death. If the government says only some testamentary trusts are for genuine purposes, it implies other trusts created by wills may somehow be treated as insufficiently genuine.

“This matters because testamentary trusts often evolve over time. They may receive superannuation death benefits, proceeds of insurance, substituted assets, reinvested capital, assets from a surviving spouse’s estate or assets transferred as part of broader family succession arrangements.

“If the exemption is drawn too narrowly, the trust may exist, but its tax usefulness may be materially reduced.”

Since budget night, and the announcement of the testamentary trust revision, Martin has been involved in calls to government to provide clarity as to what is a ‘genuine purpose’, given estate planning requires long-term forward planning.

She highlights a broad interpretation would recognise the long-standing role testamentary trusts have played in estate and succession planning, beneficiary protection and intergenerational wealth transfers, while a narrower interpretation would limit the availability of that exemption.

“The important issue here is the decision to legislate by reference to that purpose. Estate planning is different to other areas of law because relevant decisions are often made many years or decades before they take effect,” she says.

“By the time the will is pulled out after their death, the people who could explain why the testamentary trust was included may no longer be available to do that, which raises questions around how the ATO or a court is going to determine the deceased’s purpose decades after a will is signed.

“We need clarity here and I think it’s really dangerous to define that by way of purpose because it means we’re not able to give our clients any peace of mind or clarity about how that is going to be treated in the future.”

She believes the government has already narrowed the gate as to the utility of a testamentary trust with its conditional phrasing and that prior to the budget testamentary trusts had an ‘open paddock’ with established fences around it, which were long-standing statutory rules determining who could access the tax treatment. The original budget announcement locked that gate to all but those with an existing testamentary trust and the revised announcement reopened the gate, but made it clear it would be narrower moving ahead.

Hayes agrees with Martin and echoes Broderick’s view about a re-examination of who can be a testamentary trust beneficiary, suggesting it may follow the model used when considering who can be a superannuation death benefit recipient.

“I think that’s where the government will go. If you have a 30 per cent minimum tax regime in place that any other form of discretionary trust has to pay on any distribution to a beneficiary, but have none for a testamentary trust, your estate planning changes significantly,” she acknowledges.

“Rather than passing my assets directly to you, I am going to put them in a testamentary trust and that’s how you will get the income and get around the 30 per cent minimum tax.

“In that situation I am absolutely expecting it to be limited and the gates narrowed and an easy pick-up in legislation exists and that is to use the death benefits dependant definition.”

For the superannuation sector, these changes don’t have an immediate impact as the taxation of death benefits will not change and the function of reversionary pensions and binding death benefit nominations will remain the same.

What will be an issue is considering estate planning strategies, given a superannuation fund has limited utility when a member dies as it creates a compulsory cashing event, but then the pathway of the flow of money becomes important, which SuperCentral special counsel Michael Hallinan recognises is a well-trodden path.

“There has always been an issue as to whether to transfer wealth in the super fund into the estate because if there is a trust created by the estate for a particular recipient, its main advantage is the trust could exist for quite some time,” Hallinan says.

“In contrast, if the recipient is under age 18, it could be paid as a child pension directly from the super, but that would have to terminate at age 25.

“So the choice may be between having a super benefit which terminates at age 25, where the capital has to be paid out to the recipient, versus having a discretionary trust created by a will where it could be held for longer without that need to terminate at age 25.

“This is not an issue unique to SMSFs and the benefits could be in a large fund. The issue is whether the benefits can be paid to the estate where it could be held longer for the intended beneficiary compared to the super fund where benefit dependants are fairly narrowly defined as the first generation of the member.”

While they are worlds apart, the trust tax changes have, at this stage, something in common with the Division 296 tax – both were announced with scant details and people should be slow to act until those are released in a consultation paper sometime in the coming weeks or months.

In fact, Martin points to the mistakes of the early movers reacting to Division 296 as a reason not to act on the trust tax amendments, noting the government has already walked back some of the changes.

“This issue reinforces the difficult position advisers are being placed in because so many things are changing so constantly and they interact with one another in terms of amendments to superannuation, to testamentary discretionary trusts, capital gains tax, negative gearing and how we deal with that from an estate administration perspective,” she observes.

“All of them interact and yet we are expected, as lawyers, as financial advisers, as accountants, to be across all of that.

“The concern is, because of these changes and how they interact, if we give advice, and then it’s incorrect, whether we are lining ourselves up to claims that we should have known about the latest developments.

“It is still incredibly stressful and difficult to operate in an environment where the government is just imposing so much change in a very short period of time.”