A brief background to testamentary trust taxation
In our opinion, the primary reason for employing testamentary discretionary trusts is asset protection and providing the will maker with confidence his legacy will flow as intended. While taxation benefits are often touted as a reason for employing testamentary trusts, in our opinion tax benefits should be thought of as an added benefit - because as we have recently seen, taxation policy can quickly change.
That said, we thought it useful to provide a brief history of the the taxation of testamentary trusts, and insights into the governments policy and thinking.
Early Framework: Parity with Family Trusts
Initially, testamentary trusts (created by will or intestacy) were taxed similarly to discretionary family trusts established during a person’s lifetime. Key provisions of the Income Tax Assessment Act 1936 (ITAA 1936), such as sections 95A and 97, applied equally, ensuring that beneficiaries with vested interests were taxed on their share of trust income. Trustees could also stream capital gains and franked dividends to beneficiaries, leveraging Subdivision 115-C of the Income Tax Assessment Act 1997 (ITAA 1997).
A brief side note on ITAA 1936 and ITAA 1997
Both the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997) govern Australian income tax and operate concurrently. While the 1997 Act was created to simplify tax law, the 1936 Act remains necessary as several key areas (like trust income and capital gains) still rely on its complex rules. Because the rewrite has been a gradual, progressive process, the two acts must be read together. To interpret how both acts apply to a specific situation, practitioners and taxpayers rely on Dictionary provisions (found in Chapter 6 of the 1997 Act) and interaction rules.
The Minor Beneficiary Distinction
A major distinction emerged regarding distributions to beneficiaries under 18. While most minors receiving trust income are taxed at the highest marginal rate, exceptions exist for testamentary trusts. If the income qualifies as “excepted trust income” under section 102AG, minors can access adult tax rates, making testamentary trusts especially attractive for families with young beneficiaries. However, strict criteria apply, income must be derived from assets originating from the deceased estate or qualifying sources such as life insurance or compensation payments.
Anti-Avoidance and Integrity Measures
As testamentary trusts grew in popularity, the government introduced targeted anti-avoidance provisions. The 2018 federal budget announced new integrity measures, enacted in June 2020, to prevent minors from accessing concessional tax rates on income from assets not genuinely linked to a deceased estate. These rules ensure that only income from qualifying estate assets receives favourable treatment, closing loopholes around asset injections from related parties or non-arm’s length transactions.
Key anti-avoidance provisions include:
Section 100A (ITAA 1936): Targets reimbursement arrangements involving trust income allocations.
Section 98A and Division 6AAA: Address distributions to non-residents.
Subdivision 115-C (ITAA 1997): Limits capital gain streaming options for trustees.
Sections 102AG(3)–(5): Prevent non-arm’s length loans, gifts, or asset transfers from generating excepted trust income.
Types of Testamentary Trusts Recognised
Section 102AG recognises various testamentary trust structures, including:
Discretionary trusts established by will
Capital reserved trusts
Protective trusts for vulnerable beneficiaries
Trusts created under intestacy laws
Trusts funded by life insurance, superannuation, or compensation payments
Each structure has specific requirements to ensure compliance and access to tax concessions.
The Modern Landscape
Today, testamentary trusts remain a powerful estate planning tool, but their tax advantages depend on strict adherence to legislative requirements. Trustees must maintain robust records, ensure proper administration, and avoid prohibited transactions with related parties. The Australian Taxation Office continues to support concessional treatment for well-governed testamentary trusts, provided all compliance obligations are met.
Conclusion
The taxation of testamentary trusts has evolved to balance flexibility for families with safeguards against tax avoidance. At Eastern Hill Estate Planning, we help clients navigate these complexities to ensure their estate plans are both effective and compliant. If you’re considering a testamentary trust, understanding its tax history and current rules is the first step to making informed decisions for your family’s future.
