Taxation consequences of testamentary trust distributions - Part I

There has been a refocus on what is likely to be the approach of the ATO in this area.

For those that do not otherwise have access to the Weekly Tax Bulletin, the article from last week by fellow View Legal Director Patrick Ellwood and I is extracted below.

In December 2013, the Federal Government announced its decision to abandon a number of proposed legislative changes in relation to various aspects of the taxation of testamentary trusts - see 2013 WTB 53 [2270] and also 2014 WTB 12 [399]. As a result, there has been a refocus on what is likely to be the approach of the ATO in this area.

Part I of this 2-part article considers the taxation aspects of:

• the transfer of assets under a deceased estate;
• distributions from a will maker to a legal personal representative (LPR);
• distributions from a LPR to a testamentary trust.

Part II of this article will focus on distributions from testamentary trusts to beneficiaries and the abandonment of the previously announced legislative changes.

Transfer of assets

On the death of a will maker, each asset of the estate will potentially be transferred 3 times:

• from the will maker to the LPR;
• from the LPR to the beneficiary of the estate, which may be the trustee of a testamentary trust; and
• where the recipient was the trustee of a testamentary trust, from that trustee to a beneficiary either as a capital distribution during the lifetime of the trust or as a distribution of corpus upon vesting.

The CGT consequences of each of the abovementioned transfers must be separately considered.

Distributions from will maker to LPR

The first roll-over to examine is the initial transfer of a deceased's assets from the deceased person to their LPR for distribution under the terms of the deceased's will.

As a starting point, the general position is that, when a taxpayer dies, any capital gain or loss from any event relating to a CGT asset owned by the deceased is disregarded under s 128-10 of the ITAA 1997. This means that the distribution from the deceased to their LPR does not result in a CGT liability for the deceased.

As to the consequences for the LPR, the CGT assets are taken, under s 128-15 to have been acquired by the LPR on the date the deceased died. The cost base of each CGT asset (other than for a property which was a main residence for the deceased immediately before they died) for the LPR is modified under s 128-15(4) so that:

• for pre-CGT assets in the hands of the deceased - the first element of the LPR's cost base (and reduced cost base) is the market value of the asset on the day the deceased died (meaning that pre-CGT assets in the hands of the deceased become post-CGT assets in the hands of the LPR); and
• for post-CGT assets in the hands of the deceased - the first element of the LPR's cost base (and reduced cost base) is the deceased's cost base (or reduced cost base) at the date of their death (i.e. the deceased effectively passes their cost base and reduced cost base to the LPR).

Distributions from LPR to testamentary trust

From a CGT perspective, a testamentary trust is treated much the same as other trusts. However, it should be noted that CGT event E1 does not apply to the creation of a testamentary trust since that event only applies to the creation of a trust "by declaration or settlement".

In the testamentary trust scenario, there is no such declaration of trust and there is no initial settlement sum.

The CGT rules which apply to the distribution from the deceased to the LPR apply in the same manner to subsequent distributions from the LPR to a "beneficiary" of the estate.

It would appear that "beneficiary" for the purposes of the ITAA 1997 includes the trustee of a testamentary trust (however, as will be explained in Part II of this article, for the purpose of Div 128, the trustee of a testamentary trust is also treated the same as an LPR by the ATO), meaning that distributions from an LPR to the trustee of a testamentary trust are treated in the same manner as distributions from an LPR to an individual beneficiary.

A CGT asset is taken to have passed to a beneficiary of a deceased's estate if the beneficiary (or in this case, the trustee of the testamentary trust) becomes the owner of the asset whether under the terms of:

• the deceased's will;
• under the intestacy laws; or
• under a deed of arrangement.

Section 128-15(3) provides that on a subsequent distribution from the LPR to a beneficiary (including the trustee of a testamentary trust), any capital gain or loss that the LPR makes is disregarded.

Again, the trustee of the testamentary trust is taken to have acquired the CGT assets of the deceased at the date of the deceased's death (rather than on the date they were distributed by the LPR) and the first element of the cost base (and reduced cost base) for the testamentary trust trustee will be:

• for pre-CGT assets in the hands of the deceased - the market value of the asset on the day the deceased died; and
• for post-CGT assets in the hands of the deceased - the deceased's costs base (or reduced cost base) at the date of their death.

The testamentary trust trustee is also able include in its cost base any expenditure the LPR has incurred, up to the time of the disposal by the LPR, that the LPR would have been entitled to include in its cost base had it retained the asset.

Until next week.

Image credit: Barbara Agnew cc