Tax Integrity - Improving the taxation of testamentary trusts

17 October 2019

The tax treatment of testamentary trusts is being tightened, to ensure that minors who are trust beneficiaries do not receive tax concessions they are not entitled to.

Last week, the Government released draft legislation for consultation that potentially affects all testamentary trusts. If passed without amendments, the changes will apply from 1 July 2019.

The new measure will clarify that minors will be taxed at adult marginal tax rates only in respect of income a testamentary trust generates from assets of the deceased estate, or the proceeds of the disposal or investment of these assets.

The measure was first announced in the 2018–19 budget and is estimated to have a small unquantifiable gain to revenue over the forward estimates.

Mark Molesworth, BDO Tax Partner said: “Testamentary trusts are used by people who want to exert some control over their beneficiaries from the grave. One of the tax benefits of testamentary trusts is that income distributed to minors from them is taxed at normal adult rates, rather than being automatically taxed at the highest marginal rate which is what happens with most trust distributions to minors.

“Because of this feature, some people thought that it was a good idea to undertake 'trust stuffing' - where assets were added to an existing testamentary trust after the testator had died.

"The Government saw this as an unintended consequence and announced a change in the last budget to stop this practice.

"There are two issues with the proposed legislation. First, it requires that, for a minor beneficiary to get concessional tax treatment, the beneficiary must have been a part of the class of beneficiaries as that class was defined at the time of the testator's death. This is problematic because:

  • This was not part of the original budget announcement. Clearly advice on this matter issued since 1 July 2019 will need to be reviewed. The proposed  legislation has retrospective application because it potentially affects amendments to deeds already made.

  • It is unfair where the original testamentary trust document allows for the appointment of further beneficiaries (or classes of beneficiaries). The testator may have relied on this power and the discretion of his/her trustees to ‘do right’, rather than trying to imagine every potential class of beneficiaries that he or she may want to benefit under the testamentary trust. The legislation assumes that the terms of the testamentary trust are thought about and set by the testator immediately before death and with the benefit of full knowledge. This is not always the case.

For Example:

10 years ago, Linda drafted her will, including a testamentary trust to benefit “my children and, should any of my children pre-decease me, their children shall take equally the share to which their parent would have been entitled”. Over the subsequent 10 years one of Linda’s sons took up a domestic relationship with a partner who was pregnant at that time by another man. The child was raised as one of the family, but not formally adopted by Linda’s son. While acknowledging the lack of familial paternity, Linda referred to the child as ‘my granddaughter’. Linda’s son pre-deceased her. After Linda’s death, the trustees of her deceased estate (her other children) received advice that it was doubtful whether the ‘granddaughter’ fell into the class of beneficiaries specified in the testamentary trust document. As such, they use the power in the deed to amend the class of beneficiaries to include that granddaughter, as they believed that was in accordance with Linda’s wishes. Under the amendments, the 'granddaughter' doesn't get the concessional tax treatment.

"The second issue is the extensive use in the draft law of the words ’in the opinion of the Commissioner’.

"Australia operates a self-assessment tax system. The matters that the law requires the Commissioner to form an opinion on are capable of objective proof. There is no place in a self-assessment system for the substitution of the Commissioner's opinion for facts.

"Quite clearly it is positively harmful to efficient compliance with, and administration of, the law where the satisfaction of the Commissioner’s opinion becomes the touchpoint for challenge, rather than objectively observable facts. While this sort of language is used extensively in the current law on testamentary trusts, that is no excuse to perpetuate its use; in fact it is a reason to take this opportunity to expunge it from the other places where it appears in this part of the law.”

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