Injected capital will trap testamentary trusts

testamentary trust capital

SMSFs are neglecting to keep capital sources separate when using a testamentary trust and may lose associated tax concessions.

SMSF trustees considering the use of a testamentary trust to pass on benefits or assets from their estate to a minor are overlooking the fact the trust must not receive capital from any other sources to retain its favourable tax status.

Speaking during a recent webinar, DBA Lawyers senior associate William Fettes said despite many industry participants being aware of the changes made to section 102 AG of the Income Tax Assessment Act 1936, there was still a lack of understanding around its operation.

Fettes noted rules regarding the application of concessional tax rates to income from a testamentary trust where it was distributed to a minor were familiar to many, but section 102 AG added further constraints.

“This subsection seeks to limit the concession of accepted trust income to property directly devolved from a deceased estate,” he said.

“The rule more technically provides that it needs to be income derived on property that is transferred from the deceased estate testamentary trust, plus accumulations of income or capital in respect of that property.”

He noted testamentary trusts that have received cash and then converted it into a different investment form should be within the legal boundaries, but warned trustees about capital coming from other sources.

“We need to be mindful of what I would call ‘injected capital’ and the provisions are really aimed at denying adult marginal tax rate concessions for income that is distributed to minors where there is not this direct devolution from the estate,” he said.

“The examples given in the explanatory materials for this legislation really cover this concept of a discretionary trust making a distribution to a testamentary trust in effect to increase the pool of assets.

“And in that case the injected capital and the income on that capital will not be relevant for accepted trust income status when it is distributed to a minor.

“Only a proportionate share of the income that reflects the organic property of the testamentary trust that devolved from the estate will attract accepted income status, not the share that’s reflective of the injected amount.

“There already was an integrity rule, perhaps not particularly well enforced by the commissioner, but now we have a more specific integrity rule which definitely rules out those kinds of gifting arrangements or distribution arrangements from outside of the estate.”

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